UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2015
or
For the transition period from to .
Commission file number: 001-37497
LIVE OAK BANCSHARES, INC.
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1741 Tiburon Drive
Wilmington, North Carolina
(910) 790-5867
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of November 12, 2015, there were approximately 29,447,381 shares of the registrant’s voting common stock outstanding and approximately 4,723,530 shares of the registrant’s non-voting common stock outstanding.
Live Oak Bancshares, Inc. and Subsidiaries
Form 10-Q
For the Quarterly Period Ended September 30, 2015
TABLE OF CONTENTS
Consolidated Statements of Comprehensive Income for the Three and Nine Months ended September 30, 2015 and 2014
PART I. FINANCIAL INFORMATION
Live Oak Bancshares, Inc.
Consolidated Balance Sheets
As of September 30, 2015 (unaudited) and December 31, 2014*
(Dollars in thousands)
Assets
Cash and due from banks
Certificates of deposit with other banks
Investment securities available-for-sale
Loans held for sale
Loans held for investment
Allowance for loan losses
Net loans
Premises and equipment, net
Foreclosed assets
Servicing assets
Investments in non-consolidated affiliates
Other assets
Total assets
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Short term borrowings
Long term borrowings
Other liabilities
Total liabilities
Shareholders’ equity
Non-cumulative perpetual preferred stock (Series A), 6,800 shares authorized, issued and outstanding
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at September 30, 2015 and December 31, 2014
Class A common stock, no par value, 100,000,000 shares authorized, 29,443,970 and 23,896,400, shares issued and outstanding at September 30, 2015 and December 31, 2014, respectively
Class B common stock, no par value, 10,000,000 shares authorized, 4,723,530 shares issued and outstanding at September 30, 2015 and December 31, 2014
Retained earnings (accumulated deficit)
Accumulated other comprehensive income
Total shareholders’ equity attributed to Live Oak Bancshares, Inc.
Noncontrolling interest
Total equity
Total liabilities and shareholders’ equity
See Notes to Consolidated Financial Statements
1
Consolidated Statements of Income
For the three and nine months ended September 30, 2015 and 2014 (unaudited)
(Dollars in thousands, except per share data)
Interest income
Loans and fees on loans
Investment securities, taxable
Other interest earning assets
Total interest income
Interest expense
Deposits
Borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income
Loan servicing revenue and revaluation
Net gains on sales of loans
Equity in loss of non-consolidated affiliates
Gain on sale of investment in non-consolidated affiliate
Gain on sale of investment securities available-for-sale
Other noninterest income
Total noninterest income
Noninterest expense
Salaries and employee benefits
Travel expense
Professional services expense
Advertising and marketing expense
Occupancy expense
Data processing expense
Equipment expense
Other expense
Total noninterest expense
Income before taxes
Income tax expense
Net income
Net loss attributable to noncontrolling interest
Net income attributable to Live Oak Bancshares, Inc.
Basic earnings per share
Diluted earnings per share
2
Consolidated Statements of Comprehensive Income
Other comprehensive income (loss) before tax:
Net unrealized gain (loss) on investment securities arising during the period
Reclassification adjustment for (gain) loss on sale of securities available-for-sale included in net income
Other comprehensive income (loss) before tax
Other comprehensive income (loss), net of tax
Total comprehensive income
3
Consolidated Statements of Changes in Shareholders’ Equity
For the nine months ended September 30, 2015 and 2014 (unaudited)
Balance at December 31, 2013
Other comprehensive income
Reclass from redeemable equity securities
Sales of common stock
Stock option exercises
Issuance of common stock grants
Common stock issued in private placement, net of offering cost
Debt conversion to common stock
Stock option based compensation expense
Reclassification adjustment for change in taxable status
Restricted stock expense
Dividends (distributions to shareholders)
Balance at September 30, 2014
Balance at December 31, 2014
Net income (loss)
Consolidation of investment with non-controlling interest
Capital contribution from non-controlling interest
Issuance of common stock in connection with initial public offering, net of issue costs
Balance at September 30, 2015
4
Consolidated Statements of Cash Flows
Cash flows from operating activities
Adjustments to reconcile net income to net cash used by operating activities:
Depreciation and amortization
Amortization of premium on securities, net of accretion
Amortization (accretion) of discount (premium) on unguaranteed loans, net
Deferred tax expense
Originations of loans held for sale
Proceeds from sales of loans held for sale
Net loss on sale of foreclosed assets
Net increase in servicing assets
Net gains on sale of loans held for sale
Gain on sale of securities available-for-sale
Net loss (gain) on disposal of premises and equipment
Stock grants
Changes in assets and liabilities:
Accounts receivable and other assets
Accrued expenses and other liabilities
Net cash used by operating activities
Cash flows from investing activities
Purchases of securities available-for-sale
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale
Proceeds from sale of foreclosed assets
Investment in certificates of deposit
Proceeds from sale of investment in non-consolidated affiliate
Capital investments in non-consolidated affiliates
Net cash acquired in consolidation of equity method investment
Loan originations and principal collections, net
Proceeds from sale of premises and equipment
Purchases of premises and equipment, net
Net cash provided (used) by investing activities
5
Consolidated Statements of Cash Flows (Continued)
Cash flows from financing activities
Net increase in deposits
Proceeds from long term borrowings
Repayment of long term borrowings
Proceeds from short term borrowings
Repayment of short term borrowings
Sale of common stock, net
Shareholder dividend distributions
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning
Cash and cash equivalents, ending
Supplemental disclosure of cash flow information
Interest paid
Income tax
Supplemental disclosures of noncash operating, investing, and financing activities
Unrealized holding gains on available-for-sale securities, net of taxes
Conversion of convertible subordinated debt into common stock
Transfers from loans to foreclosed real estate and other repossessions
Transfers from foreclosed real estate to SBA receivable
Transfers of loans accounted for as secured borrowing collateral to other assets
Transfer of loans held for sale to loans held for investment
Transfer of loans held for investment to loans held for sale
Contingent consideration in acquisition of controlling interest in equity method of investment
Non-cash dividend
6
Notes to Unaudited Consolidated Financial Statements
Note 1. Basis of Presentation
Nature of Operations
Live Oak Bancshares, Inc. (the “Company” or “LOB”) is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws 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 established in May 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within credit-worthy industries through expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 7(a) program. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank. On July 23, 2015 the Company closed on its initial public offering.
In addition to the Bank, the Company owns Independence Aviation, LLC, which was formed for the purpose of purchasing and operating aircraft used for business purposes of the Company, Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location, Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans, and 504 Fund Advisors, LLC (“504FA”), formed to serve as the investment advisor to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.
The Company acquired control over 504FA, previously carried as an equity method investment, on February 2, 2015 by increasing its ownership from 50.0% to 91.3%. The acquisition of an additional 41.3% of ownership occurred in exchange for contingent consideration estimated to total $170 thousand. Transactions in the third quarter of 2015 increased the Company’s ownership to 92.4%. With 7.6% of ownership remaining with a third party investor, amounts of earnings and equity in 504FA attributable to the third party investor are now disclosed in the Company’s consolidated financial statements as related to a noncontrolling interest.
The Company earns revenue primarily from the sale of SBA-guaranteed loans. This income is comprised of net gains on the sale of loans, revenues on the servicing of sold loans and valuation of loan servicing rights. Net interest income is another contributor to earnings. Offsetting these revenues are the cost of funding sources, provision for loan 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.
General
In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all intercompany transactions have been eliminated in consolidation. Results of operations for the nine months ended September 30, 2015 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2015. The consolidated balance sheet as of December 31, 2014 has been derived from the audited consolidated financial statements contained in the Company’s registration statement on Form S-1 (File No. 333-205126), as amended. A summary description of the significant accounting policies followed by the Company is set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s registration statement on Form S-1, as amended.
The preparation of financial statements in conformity with United States generally accepted accounting principles, or GAAP, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.
Amounts in all tables in the Notes to Unaudited Consolidated Financial Statements have been presented in thousands, except percentage, time period, stock option, share and per share data.
Stock Split
On September 23, 2014, the Board of Directors declared a ten-for-one stock split of the Company’s Class A and Class B common shares, which was effected in the form of a common stock dividend distributed on October 10, 2014. Except for the amount of authorized shares, all references to share and per share amounts in the consolidated financial statements and accompanying notes to the consolidated financial statements have been retroactively restated to reflect the stock split.
7
Note 1. Basis of Presentation (Continued)
Business Segments
Management has determined that the Company has one significant operating segment, which is providing a lending platform for small businesses nationwide. In determining the appropriateness of segment definition, the Company considers the materiality of a potential segment, the components of the business about which financial information is available, and components for which management regularly evaluates relative to resource allocation and performance assessment.
Reclassifications
Certain reclassifications have been made to the prior period’s consolidated financial statements to place them on a comparable basis with the current year. Net income and shareholders’ equity previously reported were not affected by these reclassifications.
Note 2 - Recent Accounting Pronouncements
In January 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2015-01, “Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items” (“ASU 2015-01”). ASU 2015-01 eliminated from U.S. GAAP the concept of an extraordinary item, which is an event or transaction that is both unusual in nature and infrequently occurring. The guidance will be effective for the Company for interim and annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect this guidance to have a material effect on its consolidated financial statements.
In February 2015, the FASB issued Accounting Standards Update No. 2015-02, “Amendments to the Consolidation Analysis” (“ASU 2015-02”). ASU 2015-02 amended the consolidation requirements in Accounting Standards Codification (“ASC”) 810 Consolidation. The amendments change the consolidation analysis required under U.S. GAAP, and modify how variable interests held by a reporting entity’s related parties affect its consolidation conclusions. The amendments will be effective for the Company for interim and annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its consolidated financial statements.
In April 2015, the FASB issued ASU 2015-05, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) – Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” ASU 2015-05 addresses accounting for fees paid by a customer in cloud computing arrangements such as (i) software as a service, (ii) platform as a service, (iii) infrastructure as a service and (iv) other similar hosting arrangements. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 will be effective for the Company on January 1, 2016 and is not expected to have a significant impact on its consolidated financial statements.
In May 2015, the FASB issued ASU 2015-07, “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent) (a Consensus of the Emerging Issues Task Force).” The new guidance eliminates the requirement to classify in the fair value hierarchy any investments for which fair value is measured at net asset value per share using the practical expedient. This guidance is effective for interim and annual periods beginning after December 15, 2015. The adoption of this guidance is not expected to be material to the consolidated financial statements.
In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805) – Simplifying the Accounting for Measurement-Period Adjustments.” ASU 2015-16 requires that adjustments to provisional amounts that are identified during the measurement period of a business combination be recognized in the reporting period in which the adjustment amounts are determined. Furthermore, the income statement effects of such adjustments, if any, must be calculated as if the accounting had been completed at the acquisition date. The portion of the amount recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. Under previous guidance, adjustments to provisional amounts identified during the measurement period are to be recognized retrospectively. ASU 2015-16 will be effective for the Company on January 1, 2016 and is not expected to have a significant impact on the consolidated financial statements.
8
Note 3. Earnings Per Share
Basic and diluted earnings per share are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur, upon the exercise of stock options or upon the vesting of restricted stock grants, any of which would result in the issuance of common stock that would then be shared in the net income of the Company.
Basic earnings per share:
Net income available to common shareholders
Weighted-average basic shares outstanding
Diluted earnings per share:
Net income available to common shareholders, for diluted earnings per share
Total weighted-average basic shares outstanding
Add effect of dilutive stock options and restricted stock grants
Total weighted-average diluted shares outstanding
Anti-dilutive shares
Pro forma earnings per share
Because the Company was not a taxable entity prior to August 3, 2014, pro forma amounts for income tax expense and basic and diluted earnings per share have been presented below assuming the Company’s effective tax rate of 38.5% for the three and nine months ended September 30, 2014.
Pro forma net income available to common shareholders, after tax
Pro forma basic earnings per share
Pro forma diluted earnings per share
9
Note 4. Securities
The carrying amount of securities and their approximate fair values are reflected in the following table:
September 30, 2015
US government agencies
Residential mortgage-backed securities
Mutual fund
December 31, 2014
During the three months ended September 30, 2015, the Company sold three US government agency securities for $8.3 million at a gain of $12 thousand and purchased four mortgage-backed securities totaling $9.5 million in a transaction designed to enhance cashflow and yield. In addition, during the first and second quarters of 2015, the Company sold six mortgage-backed securities at their carrying amount for $3.4 million in an odd-lot consolidation and purchased two mortgage-backed securities for $4.0 million for the purpose of complying with the Community Reinvestment Act. The Company also invested $1.9 million in the 504 Fund mutual fund. The investment in this mutual fund was purchased at current market value (190,380.762 shares at $9.98 per share). During the nine months ending September 30, 2015, there was $30 thousand of dividend reinvestment in the 504 Fund mutual fund as well. There were no calls or maturities of securities during the three and nine months ending September 30, 2015.
During the three months and nine months ended September 30, 2014, there were purchases of five US government agency securities for $29.9 million as part of a strategic investment plan to utilize excess cash from the $74.6 million private placement capital raise that took place in August 2014 and one mortgage-backed security purchased for $1.6 million for the purpose of complying with the Community Reinvestment Act. There were no calls, sales or maturities of securities during the three and nine months ended September 30, 2014.
The following tables show gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
Total
10
Note 4. Securities (Continued)
At September 30, 2015, there were three mortgage-backed securities in unrealized loss positions for greater than 12 months and nine mortgage-backed securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2014, were comprised of six securities, consisting of one US government agency security and five mortgage-backed securities, in unrealized loss positions for greater than 12 months and one mortgage-backed security in an unrealized loss position for less than 12 months.
These unrealized losses are primarily the result of volatility in the market and are related to market interest rates. Since none of the unrealized losses relate to marketability of the securities or the issuer’s ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired.
All residential mortgage-backed securities in the Company’s portfolio at September 30, 2015 and December 31, 2014 were backed by US government sponsored enterprises (“GSEs”).
The following is a summary of investment securities by maturity:
One to five years
Five to ten years
After 10 years
The table above reflects contractual maturities. Actual results will differ as the loans underlying the mortgage-backed securities may repay sooner than scheduled. This table excludes the 504 Fund mutual fund investment.
At September 30, 2015 and December 31, 2014, investment securities with a fair market value of $1.3 million were pledged to secure a line of credit with the Company’s correspondent bank.
11
Note 5. Loans and Allowance for Loan Losses
Loan Portfolio Segments
The following describes the risk characteristics relevant to each of the portfolio segments. Each loan category is assigned a risk grade during the origination and closing process based on criteria described later in this section.
Commercial and Industrial
Commercial and industrial loans (C&I) receive similar underwriting treatment as commercial real estate loans in that the repayment source is analyzed to determine its ability to meet cash flow coverage requirements as set forth by Bank policies. Repayment of the Bank’s C&I loans generally comes from the generation of cash flow as the result of the borrower’s business operations. This business cycle itself brings a certain level of risk to the portfolio. In some instances, these loans may carry a higher degree of risk due to a variety of reasons – illiquid collateral, specialized equipment, highly depreciable assets, uncollectable accounts receivable, revolving balances, or simply being unsecured. As a result of these characteristics, the SBA guarantee on these loans is an important factor in mitigating risk.
Construction and Development
Construction and development loans are for the purpose of acquisition and development of land to be improved through the construction of commercial buildings. Such loans are usually paid off through the conversion to permanent financing for the long-term benefit of the borrower’s ongoing operations. At the completion of the project, if the loan is converted to permanent financing or if scheduled loan amortization begins, it is then reclassified to the “Owner Occupied Commercial Real Estate” segment. Underwriting of construction and development loans typically includes analysis of not only the borrower’s financial condition and ability to meet the required debt obligations, but also the general market conditions associated with the area and type of project being funded.
Owner Occupied Commercial Real Estate
Owner occupied commercial real estate loans are extensions of credit secured by owner occupied collateral. Underwriting generally involves intensive analysis of the financial strength of the borrower and guarantor, liquidation value of the subject collateral, the associated unguaranteed exposure, and any available secondary sources of repayment, with the greatest emphasis given to a borrower’s capacity to meet cash flow coverage requirements as set forth by Bank policies. Such repayment of owner-occupied loans is commonly derived from the successful ongoing operations of the business occupying the property. These typically include small businesses and professional practices.
Commercial Land
Commercial land loans are extensions of credit secured by farmland. Such loans are often for land improvements related to agricultural endeavors that may include construction of new specialized facilities. These loans are usually repaid through the conversion to permanent financing, or if scheduled loan amortization begins, for the long-term benefit of the borrower’s ongoing operations. Underwriting generally involves intensive analysis of the financial strength of the borrower and guarantor, liquidation value of the subject collateral, the associated unguaranteed exposure, and any available secondary sources of repayment, with the greatest emphasis given to a borrower’s capacity to meet cash flow coverage requirements as set forth by Bank policies.
Each of the loan types referenced in the sections above is further segmented into verticals in which the Bank chooses to operate. The Bank chooses to finance businesses operating in specific industries because of certain similarities. The similarities range from historical default and loss characteristics to business operations. However, there are differences that create the necessity to underwrite these loans according to varying criteria and guidelines. When underwriting a loan, the Bank considers numerous factors such as cash flow coverage, the credit scores of the guarantors, revenue growth, practice ownership experience and debt service capacity. Minimum guidelines have been set with regard to these various factors and deviations from those guidelines require compensating strengths when considering a proposed loan.
12
Note 5. Loans and Allowance for Loan Losses (Continued)
Loans consist of the following:
Commercial & Industrial
Agriculture
Death Care Management
Healthcare
Independent Pharmacies
Registered Investment Advisors
Veterinary Industry
Other Industries
Construction & Development
Total Loans 1
Net Deferred Costs
Discount on SBA 7(a) Unguaranteed 2
Loans, Net of Unearned
13
Credit Risk Profile
The Bank uses internal loan reviews to assess the performance of individual loans by industry segment. An independent review of the loan portfolio is performed annually by an external firm. The goal of the Bank’s annual review of each borrower’s financial performance is to validate the adequacy of the risk grade assigned.
The Bank uses a grading system to rank the quality of each loan. The grade is periodically evaluated and adjusted as performance dictates. Loan grades 1 through 4 are passing grades and grade 5 is special mention. Collectively, grades 6 through 8 represent classified loans in the Bank’s portfolio. The following guidelines govern the assignment of these risk grades:
Exceptional Loans (1 Rated): These loans are of the highest quality, with strong, well-documented sources of repayment. Debt service coverage (“DSC”) is over 1.75X based on historical results. Secondary source of repayment is strong, with a loan to value (“LTV”) of 65% or less if secured solely by commercial real estate (“CRE”). Discounted collateral coverage from all sources should exceed 125%. Guarantors have credit scores above 740.
Quality Loans (2 Rated): These loans are of good quality, with good, well-documented sources of repayment. DSC is over 1.25X based on historical or pro-forma results. Secondary source of repayment is good, with a LTV of 75% or less if secured solely by CRE. Discounted collateral coverage should exceed 100%. Guarantors have credit scores above 700.
Acceptable Loans (3 rated): These loans are of acceptable quality, with acceptable sources of repayment. DSC of over 1.00X based on historical or pro-forma results. Companies that do not meet these credit metrics must be evaluated to determine if they should be graded below this level.
Acceptable Loans (4 rated): These loans are considered very weak pass. These loans are riskier than a 3-rated credit, but due to various mitigating factors are not considered a Special Mention or worse. The mitigating factors must clearly be identified to offset further downgrade. Examples of loans that may be put in this category include start-up loans and loans with less than 1:1 cash flow coverage with other sources of repayment.
Special mention (5 rated): These loans are considered as emerging problems, with potentially unsatisfactory characteristics. These loans require greater management attention. A loan may be put into this category if the Bank is unable to obtain financial reporting from a company to fully evaluate its position.
Substandard (6 rated): Loans graded Substandard are inadequately protected by current sound net worth, paying capacity of the borrower, or pledged collateral. They typically have unsatisfactory characteristics causing more than acceptable levels of risk, and have one or more well-defined weaknesses that could jeopardize the repayment of the debt.
Doubtful (7 rated): Loans graded Doubtful have inherent weaknesses that make collection or liquidation in full questionable. Loans graded Doubtful must be placed on non-accrual status.
Loss (8 rated): Loss rated loans are considered uncollectible and of such little value that their continuance as an active Bank asset is not warranted. The asset should be charged off, even though partial recovery may be possible in the future.
14
The following tables summarize the risk grades of each category:
15
16
Past Due Loans
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans less than 30 days past due and accruing are included within current loans shown below. The following tables show an age analysis of past due loans as of the dates presented.
Total1
17
18
Nonaccrual Loans
Loans that become 90 days delinquent, or in cases where there is evidence that the borrower’s ability to make the required payments is impaired, are placed in nonaccrual status and interest accrual is discontinued. If interest on nonaccrual loans had been accrued in accordance with the original terms, interest income would have increased by approximately $358 thousand and $56 thousand for the three months ended September 30, 2015 and 2014, respectively, and for the nine months ended September 30, 2015 and 2014 interest income would have increased approximately $665 thousand and $147 thousand, respectively. All nonaccrual loans are included in the held for investment portfolio.
Nonaccrual loans as of September 30, 2015 and December 31, 2014 are as follows:
19
Allowance for Loan Loss Methodology
The methodology and the estimation process for calculating the Allowance for Loan Losses (“ALL”) is described below:
Estimated credit losses should meet the criteria for accrual of a loss contingency, i.e., a provision to the ALL, set forth in GAAP. The Company’s methodology for determining the ALL is based on the requirements of GAAP, the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other regulatory and accounting pronouncements. The ALL is determined by the sum of three separate components: (i) the impaired loan component, which addresses specific reserves for impaired loans; (ii) the general reserve component, which addresses reserves for pools of homogeneous loans; and (iii) an unallocated reserve component (if any) based on management’s judgment and experience. The loan pools and impaired loans are mutually exclusive; any loan that is impaired is excluded from its homogenous pool for purposes of that pool’s reserve calculation, regardless of the level of impairment.
The ALL policy for pooled loans is governed in accordance with banking regulatory guidance for homogenous pools of non-impaired loans that have similar risk characteristics. The Company follows a consistent and structured approach for assessing the need for reserves within each individual loan pool.
Loans are considered impaired when, based on current information and events, it is probable that the creditor will be unable to collect all interest and principal payments due according to the originally contracted, or reasonably modified, terms of the loan agreement. The Company has determined that loans that meet the criteria defined below must be reviewed quarterly to determine if they are impaired.
Any loan determined to be impaired is subjected to an impairment analysis, which is a calculation of the probable loss on the loan. This portion is the loan’s “impairment,” and is established as a specific reserve against the loan, or charged against the ALL.
Individual specific reserve amounts imply probability of loss and may not be carried in the reserve indefinitely. When the amount of the actual loss becomes reasonably quantifiable, the amount of the loss is charged off against the ALL, whether or not all liquidation and recovery efforts have been completed. If the total amount of the individual specific reserve that will eventually be charged off cannot yet be sufficiently quantified but some portion of the impairment can be viewed as a confirmed loss, then the confirmed loss portion should be charged off against the ALL and the individual specific reserve reduced by a corresponding amount.
For impaired loans, the reserve amount is calculated on a loan-specific basis. The Company utilizes two methods of analyzing impaired loans not guaranteed by the SBA:
20
The following tables detail activity in the allowance for loan losses by portfolio segment allowance for the periods presented:
Beginning Balance
Charge offs
Recoveries
Provision
Ending Balance
September 30, 2014
The following tables detail the recorded allowance for loan losses and the investment in loans related to each portfolio segment, disaggregated on the basis of impairment evaluation methodology:
Allowance for Loan Losses:
Loans individually evaluated for impairment
Loans collectively evaluated for impairment
Total allowance for loan losses
Loans receivable 1:
Total loans receivable
21
Loans Receivable 1:
22
Loans individually evaluated for impairment as of the dates presented are summarized in the following tables.
23
The following table presents evaluated balances of loans classified as impaired at the dates presented that carried an associated reserve as compared to those with no reserve. The recorded investment includes accrued interest and net deferred loan fees or costs.
Total Commercial & Industrial
Total Owner Occupied Commercial Real Estate
Total Impaired Loans
24
25
The following table represent the types of TDRs that were made during the periods presented:
Interest Only
Total Interest Only
Extended Amortization
Total Extended Amortization
Payment Deferral
Deathcare Management
Total Payment Deferral
26
Concessions made to improve a loan’s performance have varying degrees of success. No TDRs that were modified within the twelve months ended September 30, 2015 subsequently defaulted during the three and nine months ended September 30, 2015. During the three and nine months ended September 30, 2014, one TDR that was modified within the twelve months ended September 30, 2014 subsequently defaulted. This TDR was an owner occupied commercial real estate deathcare management loan that was previously modified for payment deferral. The recorded investment for this TDR at September 30, 2014 was $217 thousand.
Note 6. Servicing Assets
Loans serviced for others are not included in the accompanying balance sheet. The unpaid principal balances of loans serviced for others were $1.79 billion and $1.47 billion at September 30, 2015 and December 31, 2014, respectively.
The following summarizes the activity pertaining to servicing rights:
Balance at beginning of period
Additions, net
Changes in fair value
Balance at end of period
The fair value of servicing rights was determined using discount rates ranging from 9.23% to 13.52% on September 30, 2015, and 6.45% to 12.52% on September 30, 2014. The fair value of servicing rights was determined using prepayment speeds ranging from 4.05% to 9.90% on September 30, 2015 and 1.89% to 9.24% on September 30, 2014, depending on the stratification of the specific right. Changes to fair value are reported in loan servicing revenue and revaluation.
The fair value of servicing rights is highly sensitive to changes in underlying assumptions. Changes in prepayment speed assumptions have the most significant impact on the fair value of servicing rights. Generally, as interest rates rise on variable rate loans, loan prepayments increase due to an increase in refinance activity, which results in a decrease in the fair value of servicing assets. Measurement of fair value is limited to the conditions existing and the assumptions used as of a particular point in time, and those assumptions may not be appropriate if they are applied at a different time.
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Note 7. Borrowings
Total outstanding short and long term borrowings consisted of the following:
On September 18, 2014, the Company entered into a line of credit of $6.1 million with an unaffiliated commercial bank, secured by 1,900,000 shares of common stock of nCino, Inc., a former subsidiary of the Company. At December 31, 2014 there was $6.1 million advanced on the line of credit. Interest accrues at 30 day LIBOR (0.16% at December 31, 2014) plus 3.50% for a term of 12 months. Payments are interest only with all principal and accrued interest due on September 18, 2015. This loan was repaid in full on February 23, 2015.
Total short term borrowings
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Note 7. Borrowings (Continued)
In April 2011, the Company elected to participate in the U.S. Treasury’s Small Business Lending Fund program (“SBLF”) whereby the U.S. Treasury agreed to purchase $6.8 million in senior securities. During the initial interest period the applicable interest rate was set at 1.5%. For all remaining interest periods, which commenced on January 1, 2012, the interest rate is determined based on a formula which encompasses the percentage change in qualified lending as well as a non-qualifying portion percentage. This rate can range from 1.5% to 10.8%. At September 30, 2015 the interest rate was 1.50%. Interest is payable quarterly in arrears. With the approval of the Company’s regulator, the Company may exit the Small Business Lending Fund at any time simply by repaying the funding provided along with any accrued but unpaid interest. If the institution wishes to repay its SBLF funding in partial payments, each partial payment must be at least 25% of the original funding amount. All senior securities will mature on September 13, 2021 at which time all principal and accrued interest will be due.
On May 12, 2014, Independence Aviation financed the purchase of an airplane by entering into a promissory note with an unaffiliated commercial bank in the amount of $6 million which carries a fixed rate of 4.97% for a term of 59 months. Monthly payments are set at $48 thousand with all principal and accrued interest due on May 12, 2019.
On September 11, 2014, the Company financed the construction of an additional building located on the Company’s Tiburon Drive main campus for a $24 million construction line of credit with an unaffiliated commercial bank, secured by both properties at its Tiburon Drive main facility location. Payments are interest only through September 11, 2016 at a fixed rate of 3.95% for a term of 84 months. Monthly principal and interest payments beginning in October 2016 will be $146 thousand with all principal and accrued interest due on September 11, 2021. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios. The construction line is fully disbursed and there was no remaining available credit on this construction line at September 30, 2015.
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On September 18, 2014, the Company entered into a note payable revolving line of credit of $8.1 million with an unaffiliated commercial bank, with the first advance of $5 million on December 14, 2014. The note is unsecured and accrues interest at LIBOR plus 3.50% for a term of 36 months. The current rate is 3.693%. Payments are interest only with all principal and accrued interest due on September 18, 2017. There is no outstanding balance at September 30, 2015; therefore, there is $8.1 million of available credit on this note at September 30, 2015.
On August 1, 2014, the Company entered into a note payable line of credit of $15 million with an unaffiliated commercial bank, secured by 100% of Live Oak Banking Company’s outstanding common stock. Interest accrues at LIBOR plus 4.00% for a term of 36 months. Payments are interest only with all principal and accrued interest due on August 1, 2017. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios. This note was repaid in full on July 29, 2015.
On March 10, 2015, Independence Aviation refinanced an existing loan with Live Oak Banking Company and entered into a new loan with an unaffiliated commercial bank in the amount of $1.2 million which carries a fixed rate of 4.96% for a term of 51 months. Monthly payments are set at $9 thousand with all principal and accrued interest due on June 10, 2019.
On February 23, 2015 the Company transferred two related party loans to an unaffiliated commercial bank in exchange for $4.7 million. The exchange price equated to the unpaid principal balance plus accrued but uncollected interest at the time of transfer. The terms of the transfer agreement with the unaffiliated commercial bank identified the transaction as a secured borrowing for accounting purposes. Interest accrues at prime plus 1% with monthly principal and interest payments over a term of 60 months. The interest rate at September 30, 2015 is 4.25%. The maturity date is October 5, 2019. The pledged collateral is classified in other assets with a fair value of $4.5 million at September 30, 2015. Underlying loans carry a risk grade of 3 and are current with no delinquencies. The terms of this loan require the Company to maintain minimum capital, liquidity and Texas ratios.
With the acquisition of GLS on September 1, 2013, the Company assumed the obligation to pay a former GLS partner $250 thousand at $10 thousand a month over a 24 month period. This obligation was paid in full on August 17, 2015.
Total long term borrowings
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Note 8. Fair Value of Financial Instruments
Fair Value Hierarchy
There are three levels of inputs in the fair value hierarchy that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities.Level 2 financial instruments are valued using quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.
Financial Instruments Measured at Fair Value
The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the fair value hierarchy:
Investment Securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, discounted cash flow or at net asset value per share. Level 2 securities would include US government agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.
The Company invested $1.9 million in the 504 Fund mutual fund on March 31, 2015 and accordingly identified it as a Level 1 investment on that date. During the second quarter of 2015, the Company transferred this $1.9 million investment from Level 1 to Level 2, where it continues to be classified.
Impaired Loans: Impairment of a loan is based on the fair value of the collateral of the loan for collateral-dependent loans. Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. For non-collateral dependent loans, impairment is determined by the present value of expected future cash flows. Impaired loans classified as Level 3 are based on management’s judgment and estimation.
Servicing Assets: Servicing rights do not trade in an active, open market with readily observable prices. While sales of servicing rights do occur, the precise terms and conditions typically are not readily available. Accordingly, the Company estimates the fair value of servicing rights using discounted cash flow models incorporating numerous assumptions from the perspective of a market participant including servicing income, servicing costs, market discount rates and prepayment speeds. Due to the nature of the valuation inputs, servicing rights are classified within Level 3 of the valuation hierarchy.
Foreclosed Assets: Foreclosed real estate is adjusted to fair value less selling costs upon transfer of the loans to foreclosed real estate. Subsequently, foreclosed real estate is carried at the lower of carrying value or fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records foreclosed real estate as nonrecurring Level 3. Foreclosed assets classified as Level 3 are based on management’s judgment and estimation.
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Note 8. Fair Value of Financial Instruments (Continued)
Recurring Fair Value
The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.
Servicing assets1
Total assets at fair value
Non-recurring Fair Value
The tables below present the recorded amount of assets and liabilities measured at fair value on a non-recurring basis.
Impaired loans
Level 3 Analysis
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of September 30, 2015 and December 31, 2014 the significant unobservable inputs used in the fair value measurements were as follows:
Level 3 Assets with SignificantUnobservable Inputs
Impaired Loans
Foreclosed Assets
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Estimated Fair Value of Other Financial Instruments
GAAP also requires disclosure of fair value information about financial instruments carried at book value on the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments not measured at fair value on the balance sheets:
Cash and due from banks: The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.
Certificates of deposit with other banks: The fair value of certificates of deposit with other banks is estimated based on discounting cash flows using the rates currently offered for instruments of similar remaining maturities.
Loans held for sale: The fair values of loans held for sale are based on quoted market prices, where available, and determined by discounting estimated cash flows using interest rates approximating the Company’s current origination rates for similar loans adjusted to reflect the inherent credit risk.
Loans: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.
Accrued Interest: The carrying amounts of accrued interest approximate fair value.
Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
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Short and long term borrowings: The fair values of the Company’s short term borrowings approximate fair value while long term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental debt rates for similar types of debt arrangements.
The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:
Financial assets
Investment securities, available-for-sale
Loans, net of allowance for loan losses
Accrued interest receivable
Financial liabilities
Accrued interest payable
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Note 9. Commitments and Contingencies
Litigation
In the normal course of business the Company is involved in various legal proceedings. Management believes that the outcome of such proceedings will not materially affect the financial position, results of operations or cash flows of the Company.
Financial Instruments with Off-balance-sheet Risk
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheet.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments is as follows:
Commitments to extend credit
Plexus Capital - Fund II Investment Commitment
Plexus Capital - Fund III Investment Commitment
Total unfunded off-balance sheet credit risk
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties. In 2012, the Company began issuing commitment letters after approval of the loan by the Credit Department. Commitment letters generally expire ninety days after issuance.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Company deems necessary. There were no standby letters of credit for the periods presented.
Concentrations of Credit Risk
Although the Company is not subject to any geographic concentrations, a substantial amount of the Company’s loans and commitments to extend credit have been granted to customers in the independent pharmacy and veterinary verticals. The concentrations of credit by type of loan are set forth in Note 5. The distribution of commitments to extend credit approximates the distribution of loans outstanding. The Company does not have a significant number of credits to any single borrower or group of related borrowers whereby their retained exposure exceeds $2.0 million, except for one relationship that has a retained exposure of $2.8 million.
The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.
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Note 10. Stock Plans
On March 20, 2015, the Company adopted the 2015 Omnibus Stock Incentive Plan which replaced the previously existing Amended Incentive Stock Option Plan and Nonstatutory Stock Option Plan. The 2015 Omnibus Plan authorized awards covering a maximum of 4,300,000 common voting shares and has an expiration date of March 20, 2025. Options or restricted shares granted under this plan expire no more than 10 years from date of grant. Exercise prices under the plan are set by the Board of Directors at the date of grant, but shall not be less than 100% of fair market value of the related stock at the date of the grant. Options or restricted shares vest over a minimum of three years from the date of the grant.
Stock Options
Compensation cost relating to share-based payment transactions are recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. For the three months ended September 30, 2015 and 2014, the Company recognized $431 thousand and $33 thousand in compensation expense for stock options, respectively. For the nine months ended September 30, 2015 and 2014, the Company recognized $726 thousand and $112 thousand in compensation expense for stock options, respectively.
Stock option activity under the plan during the nine month periods ended September 30, 2015 and 2014 is summarized below.
Outstanding at December 31, 2014
Exercised
Forfeited
Granted
Outstanding at September 30, 2015
Exercisable at September 30, 2015
Outstanding at December 31, 2013
Outstanding at September 30, 2014
Exercisable at September 30, 2014
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Note 10. Stock Plans (Continued)
The following is a summary of non-vested stock option activity for the Company for the nine months ended September 30, 2015 and 2014.
Non-vested at December 31, 2014
Vested
Non-vested at September 30, 2015
Non-vested at December 31, 2013
Non-vested at September 30, 2014
The total intrinsic value of options exercised at September 30, 2015 and 2014 was $392 thousand and $771 thousand, respectively.
At September 30, 2015, unrecognized compensation costs relating to stock options amounted to $13.1 million which will be expensed over the next 7 years.
The weighted average fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The expected volatility is based on historical volatility. The risk-free interest rates for periods within the contractual life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life is based on historical exercise experience. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts. Weighted average assumptions used for options granted during 2015 were as follows: risk free rate of 1.96%, dividend yield of 1.00%, volatility of 43.38% and average life of 4-7 years.
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Restricted Stock
Restricted stock activity under the plan during the first nine months of 2015 is summarized below.
For the three months ended September 30, 2015 and 2014, the Company recognized $67 thousand and a credit of ($19) thousand in compensation expense due to forfeited shares for restricted stock, respectively. For the nine months ended September 30, 2015 and 2014, the Company recognized $83 thousand and $143 thousand in compensation expense for restricted stock, respectively.
At September 30, 2015, unrecognized compensation costs relating to restricted stock amounted to $959 thousand which will be expensed over the next 3.75 years.
The fair value of each restricted stock unit is based on the market value of the Company’s stock on the date of the grant.
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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 LOB. This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this quarterly report on Form 10-Q. Results of operations for the periods included in this review 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 Company’s financial condition, results of operations, plans, objectives, future performance or business. They usually can be identified by the use of forward-looking terminology, such as “believes,” “expects,” or “are expected to,” “plans,” “projects,” “goals,” “estimates,” “may,” “should,” “could,” “would,” “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 quarterly report on Form 10-Q. 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 quarterly report on Form 10-Q 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:
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Except as otherwise disclosed, forward-looking statements do not reflect: (i) the effect of any acquisitions, divestitures or similar transactions that have not been previously disclosed; (ii) any changes in laws, regulations or regulatory interpretations; or (iii) any change in current dividend or repurchase strategies, in each case after the date as of which such statements are made. All forward-looking statements speak only as of the date on which such statements are made, and LOB undertakes no obligation to update any statement, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements for the year ended December 31, 2014 and accompanying notes and other detailed information appearing in the Company’s registration statement on Form S-1(File No. 333-205126), as amended, filed with the SEC.
Amounts in all tables in Management’s Discussion and Analysis of Financial Condition and Results of Operations have been presented in thousands, except percentage, time period, stock option, share and per share data
Live Oak Bancshares, Inc. (the “Company” or “LOB”) is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws 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 established in May 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide in targeted industries. The Bank identifies and grows within selected industry sectors, or verticals, by leveraging expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 7(a) program. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank.
In addition to the Bank, the Company owns Independence Aviation, LLC, which was formed for the purpose of purchasing and operating aircraft used for the Company’s business purposes, Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location, Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans, and 504 Fund Advisors, LLC (“504FA”), which was formed to serve as the investment advisor to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.
The Company earns revenue primarily from the sale of SBA-guaranteed loans. This income is comprised of loan servicing revenue and revaluation and net gains on sales of loans. Net interest income is another contributor to earnings. Offsetting these revenues are the cost of funding sources, provision for loan 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.
On July 23, 2015 the Company closed on its initial public offering.
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Conversion from S Corporation to C Corporation
Effective August 3, 2014, the Company terminated its status as an “electing small business corporation,” or S corporation, under Subchapter S of the Internal Revenue Code of 1986, or the Code, and became a C corporation under the Code for income tax purposes. As a result of the conversion to a C corporation, the Company recorded a net deferred tax liability of $3.3 million on the balance sheet. Upon recognition of the deferred tax liability the Company also recorded an offsetting adjustment to income tax expense of $3.3 million, which decreased after-tax earnings and shareholders’ equity by the same amount.
Business Outlook
Below is a discussion of management’s current expectations regarding company performance over the near-term based on market conditions, the regulatory environment and business strategies as of the time the Company filed this Report. Actual outcomes and results may differ materially from what is expressed or forecasted in these forward-looking statements. See “Important Note Regarding Forward-Looking Statements” in this Report for more information on forward-looking statements.
Third quarter 2015 results demonstrated solid underlying financial performance and growth momentum for the Company. Management is focused not only on building out existing verticals but incrementally adding new verticals to the loan portfolio. The Company expects to originate approximately $1.1 billion in loans for the year 2015. Personnel and travel expenses increased during the first nine months of 2015 primarily due to further investment to support the growing loan production as well as development of a new small loan platform and other infrastructure costs, and the Company expects noninterest expense to increase consistent with the growth stage of its lifecycle.
During the first three quarters of 2015, the percentage of loans that the Company originated representing multi-advance loans increased, and the Company expects that percentage to continue on an upward trend over the next several quarters. The Company anticipates this trend will drive growth in the portfolio of loans held for sale, and a consequence of this growth will likely be an increase in the time period before gain-on-sale and servicing revenue on these loans can be realized. The Company expects a growing portfolio of loans held for sale to have a positive impact on net interest income and to partially offset the impact of the increased timing to the recognition of noninterest income. In addition, if loan production continues to increase with an increased focus on multi-advance loans, the Company also anticipates a decline over the next several quarters in the amount of loans sold as a percentage of the loans the Company originates.
Net gains on sale of loans is primarily driven by the volume of loans sold and the premium paid in the secondary market for these loans. During the third quarter of 2015, the average net gain on sale for loans sold decreased below prior quarters’ gains, which management believes was driven primarily by market conditions. There has been some stabilization in the market since the end of the third quarter, with average net gain on sale trending up from these lower levels. Market conditions indicate that trend will continue in the fourth quarter, though it is uncertain whether the premiums paid for loans that the Company sells will return to prior levels or, if so, when that may occur.
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Results of Operations
Performance Summary
Three months ended September 30, 2015 compared with three months ended September 30, 2014
For the three months ended September 30, 2015, the Company reported net income of $2.9 million, or $0.09 per diluted share, as compared to $641 thousand, or $0.02 per diluted share, for the three months ended September 30, 2014. This $2.3 million increase in quarterly net income is principally due to the following items:
Partially offsetting the above items which contributed to increased levels of net income was increased noninterest expense of $4.8 million, or 36.0%. The increased level of noninterest expense was principally driven by costs underlying increased loan production and the build out of new initiatives of the Company, including increased salaries of $3.8 million, or 62.6%, and travel expense of $389 thousand, or 21.7%.
Nine months ended September 30, 2015 compared with nine months ended September 30, 2014
For the nine months ended September 30, 2015, the Company reported net income of $14.9 million, or $0.48 per diluted share, as compared to $7.6 million, or $0.33 per diluted share, for the nine months ended September 30, 2014. This increase in net income is primarily attributable to the following items:
Partially offsetting the above items which contributed to increased levels of net income was increased noninterest expense of $10.3 million, or 26.2%. The increased level of noninterest expense was principally driven by costs underlying increased loan production and the build out of new initiatives of the Company, including increases to salaries of $5.8 million, or 26.5%, and to travel expense of $2.0 million, or 50.9%. Also partially offsetting the contributors to increased levels of net income was an increase to income tax expense of $4.3 million, or 71.9%, arising from the Company’s status as a C Corporation commencing on August 3, 2014.
Net Interest Income and Margin
Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates the Bank offer are generally above the industry average.
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For the three months ended September 30, 2015, net interest income increased $2.7 million, or 69.7%, to $6.6 million compared to the three months ended September 30, 2014. This increase was due to growth in average interest earning assets. Average interest earning assets increased by $349.1 million, or 70.7%, to $842.9 million for the three months ended September 30, 2015 compared to $493.9 million for the three months ended September 30, 2014, while the yield on average interest earning assets decreased slightly by three basis points to 4.24%. The cost of funds on interest bearing liabilities for the three months ended September 30, 2015 increased slightly by three basis points to 1.22%, and the average balance in interest bearing liabilities increased by $299.7 million, or 62.9%, over the same period. As indicated in the rate/volume table below, the slight increase in the cost of funds was outpaced by the effects of the increased volume of interest earning assets, resulting in increased interest income of $3.7 million and increased interest expense of $966 thousand for the three months ended September 30, 2015. For the three months ended September 30, 2015 compared to the three months ended September 30, 2014, net interest margin decreased from 3.13% to 3.11% due to the aforementioned effects.
For the nine months ended September 30, 2015, net interest income increased $6.6 million, or 63.7%, to $17.1 million compared to the nine months ended September 30, 2014. This increase was also due to growth in average interest earning assets. Average interest earning assets increased by $303.9 million, or 67.2%, to $756.5 million for the nine months ended September 30, 2015 compared to $452.5 million for the nine months ended September 30, 2014, while the yield on average interest earning assets decreased by nine basis points to 4.17%. The cost of funds on interest bearing liabilities for the nine months ended September 30, 2015 increased slightly by four basis points to 1.23%, and the average balance in interest bearing liabilities increased by $263.9 million, or 58.6% during the same period. As indicated in the rate/volume table below, the slight increase in the cost of funds was outpaced by the effects of the increased volume of interest earning assets, resulting in increased interest income of $9.2 million and increased interest expense of $2.5 million for the nine months ended September 30, 2015. For the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, net interest margin decreased from 3.08% to 3.02% due to the aforementioned effects.
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Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented. Loan fees are included in interest income on loans.
Interest earning assets:
Interest earning balances in other banks
Investment securities
Loans held for investment(1)
Total interest earning assets
Less: allowance for loan losses
Non-interest earning assets
Interest bearing liabilities:
Money market accounts
Certificates of deposit
Small business lending fund
Notes payable to investors
Other borrowings
Total interest bearing liabilities
Non-interest bearing deposits
Non-interest bearing liabilities
Redeemable equity
Net interest income and interest rate spread
Net interest margin
Ratio of average interest-earning assets to average interest-bearing liabilities
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Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by current volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.
Interest income:
Interest expense:
Provision for Loan Losses. The provision for loan losses represents derivation of the amount necessary to be charged against the current period’s earnings to maintain the allowance for loan losses at a level that is appropriate in relation to the estimated losses inherent in the loan portfolio. A number of factors are considered in determining the required level of loan loss reserves and the provision required to achieve the appropriate reserve level, including loan growth, credit risk rating trends, nonperforming loan levels, delinquencies, loan portfolio concentrations and economic and market trends.
Losses inherent in loan relationships are mitigated by the portion of the loan that is guaranteed by the SBA. A typical SBA 7(a) loan carries a 75% guarantee, which reduces the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from the SBA are key factors to managing this risk.
For the three months ended September 30, 2015, the provision for loan losses was $1.2 million, an increase of $700 thousand, or 136.7%, compared to the same period in 2014. This increase in provision for loan losses was principally due to growth in new lending verticals with higher loss factors due to the Company’s lack of historical loss experience in those industries and $250 thousand in charge-offs related to one loan relationship in the Veterinary Industry vertical during the third quarter of 2015.
For the nine months ended September 30, 2015, the provision for loan losses was $2.3 million, an increase of $928 thousand, or 65.8%, compared to the same period in 2014. Much of the loan growth for the nine months ended September 30, 2015 occurred within new lending verticals with higher loss factors due to the Company’s lack of historical loss experience in those industries.
Net charge-offs were $593 thousand for the nine months ended September 30, 2015, compared to net charge-offs of $557 thousand for the nine months ended September 30, 2014. In addition, at September 30, 2015, nonperforming loans not guaranteed by the SBA totaled $2.6 million, which was 1.0% of the held-for-investment loan portfolio compared to $2.3 million, or 1.4%, of loans held for investment at September 30, 2014.
Noninterest Income
Noninterest income principally represents income from the sale of SBA-guaranteed loans. This income is comprised of loan servicing revenue and revaluation and net gains on sales of loans. Revenue from the sale of loans depends upon volume and rates of loans as well as the cost and availability of funds to bridge between funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as cost to service, prepayment speeds and default rates. Other less common elements of noninterest income include nonrecurring gains and losses on investments.
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The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
Noninterest income:
Loan servicing revenue
Loan servicing revaluation
NM is defined as not meaningful.
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For the three months ended September 30, 2015, noninterest income increased by $1.3 million, or 7.7%, compared to the three months ended September 30, 2014. Increases in the serviced loan portfolio and the volume of loans sold in the secondary market, the core components of the Company’s business, contributed $2.7 million to noninterest income growth, including $358 thousand of increased servicing revenue and $2.3 million of increased net gains on sale of loans. Other increases were related to the absence of equity method investments in non-consolidated affiliates in the third quarter of 2015 as compared to the $177 thousand loss recognized in the third quarter of 2014, and an increase of $246 thousand in fees earned for monitoring higher levels of multi-advance loans in the third quarter of 2015. Offsetting the increase in noninterest income, the third quarter of 2015 also experienced an increase in the downward adjustment in the valuation of servicing rights of $2.0 million compared to the same period in 2014.
For the nine months ended September 30, 2015, noninterest income increased by $16.1 million, or 36.8%, compared to the nine months ended September 30, 2014. Increases in the serviced loan portfolio and the volume of loans sold in the secondary market, the core components of the Company’s business, contributed $12.2 million to noninterest income growth, including $1.1 million of increased servicing revenue and $11.1 million of increased net gains on sale of loans. Other increases in noninterest income were primarily the result of a $3.8 million one-time gain arising in the first quarter of 2015 related to the sale of the investment in nCino combined with an increase of $2.4 million due to minimal equity method investments in non-consolidated affiliates during the nine months ended September 30, 2015 compared to $2.4 million in losses on such investments in the nine months ended September 30, 2014, and an increase of $646 thousand in fees earned for monitoring higher levels of multi-advance loans in the nine months ended September 30, 2015. Offsetting increases in noninterest income was an increase in the downward adjustment in the valuation of servicing rights of $3.1 million during the nine months ended September 30, 2015 compared the same period in 2014.
The below tables reflect loan production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold. These components are key drivers of recurring noninterest income.
Amount of loans originated
SBA-guaranteed portions of loans sold
Outstanding balance of guaranteed loans sold (1)
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Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Revenue: While portions of the loans that the Bank originates are sold and generate premium revenue, servicing rights for all loans that the Bank originates, including loans sold, are retained by the Bank. In exchange for continuing to service loans that are sold, the Bank receives fee income represented in loan servicing revenue equivalent to one percent of the outstanding balance of the loans sold. In addition, the cost of servicing sold loans is approximately 0.40% of the balance of the loans sold, which is included in the loan servicing revaluation computations. Unrecognized servicing revenue is reflected in a servicing asset recorded on the balance sheet. Revenues associated with the servicing of loans are recognized over the expected life of the loan through the income statement, and the servicing asset is reduced as this revenue is recognized. For the three and nine months ended September 30, 2015, loan servicing revenue increased $358 thousand and $1.1 million, or 8.5% and 9.5%, respectively, compared to the three and nine months ended September 30, 2014, as a result of an increase in the average outstanding balance of guaranteed loans sold. At September 30, 2015, the outstanding balance of guaranteed loans sold in the secondary market was $1.61 billion, with a weighted average servicing rate of 1.08%. At September 30, 2014, the outstanding balance of guaranteed loans sold was $1.22 billion, with a weighted average servicing rate of 1.12%. Prior to January 2010, the Company sold loans for servicing in excess of 1.0%. As loans sold for servicing fee rates in excess of 1.0% prior to fiscal year 2010 amortize, the Company expects that the weighted average servicing rate will approach and stabilize at approximately 1.0%.
Loan Servicing Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The revaluation considers the amortization of the portfolio, current market conditions for loan sale premiums, and current prepayment speeds. For the three and nine months ended September 30, 2015, the negative loan servicing revaluation decreased the servicing asset by $2.0 million and $3.1 million, respectively, compared to the three and nine month periods ended September 30, 2014. The decline in service valuation for the three and nine month period ended September 30, 2015 compared to the same periods ended September 30, 2014 was primarily due to improving market conditions and an increase in the amortization rate of the serviced portfolio.
Net Gains on Sale of Loans: For the three and nine months ended September 30, 2015, net gains on sales of loans increased $2.3 million and $11.1 million, or 17.7% and 31.4%, respectively, compared to the three and nine month periods ended September 30, 2014. The increase in net gains on sale of loans for the three and nine month periods ended September 30, 2015 compared to the same periods in 2014 was primarily due to an increase in the volume of guaranteed loans sold. For the three months ended September 30, 2015 the volume of guaranteed loans sold increased $32.5 million, or 28.3%, from $114.9 million for the three months ended September 30, 2014 to $147.4 million for the three months ended September 30, 2015. The volume of guaranteed loans sold in the nine months ended September 30, 2015 was $421.6 million, an increase of $113.4 million, or 36.8%, from $308.2 million in guaranteed loan sales in the nine months ended September 30, 2014. The premium market had a negative impact on the net gain on sale of loans. The average net gain on sale for the three and nine months ended September 30, 2015 was somewhat lower at $105 thousand and $111 thousand of revenue for each $1 million in loans sold, respectively, compared to $114 thousand and $115 thousand of revenue for each $1 million sold for the three and nine months ended September 30, 2014, respectively.
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Noninterest Expense
Noninterest expense comprises all operating costs of the Company, such as travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.
The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.
Non-personnel expenses:
Total non-personnel expenses
Advertising and Marketing expense
Total noninterest expense for the three and nine months ended September 30, 2015 increased $4.8 million, or 36.0%, and $10.3 million, or 26.2%, respectively, compared to the same periods in 2014. The increase in noninterest expense was predominately impacted by increased personnel and travel expenses. Changes in various components of noninterest expense are discussed below.
Salaries and employee benefits: Total personnel expense for the three and nine months ended September 30, 2015 increased by $3.8 million, or 62.6%, and $5.8 million, or 26.5%, respectively, compared to the same periods in 2014. This increase primarily resulted from further investment in human capital to support the growing loan production from new and existing verticals as well as development of a new small loan platform. The increase during the nine month period ended September 30, 2015 compared to 2014 would have been larger excluding the impact of $3.0 million in non-recurring expenses in the first quarter of 2014 related to stock grants.
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Travel expense: For the three and nine months ended September 30, 2015, total travel expenses increased by $389 thousand, or 21.7%, and $2.0 million, or 50.9%, respectively, compared to the same periods in 2014. Travel costs are a crucial element of the Company’s business strategy because the Company does not maintain branch locations across its national footprint. The increase in travel-related expenses was primarily driven by growing loan production (up $43.0 million, or 16.6%, for the three months ended September 30, 2015 and $244.1 million, or 41.8%, for the nine months ended September 30, 2015). Travel costs also increased due to the Company’s customer relationship management strategy via the Company’s business advisory group, or BAG, as a result of servicing a $2.51 billion loan portfolio as of September 30, 2015. Travel expense represented 12.1% and 11.8% of total noninterest expense for the three and nine month periods ended September 30, 2015, respectively.
Professional service expense: For the three and nine months ended September 30, 2015, the total cost of professional services decreased by $1.2 million, or 66.0%, and $1.2 million, or 36.7%, respectively, compared to the same periods in 2014. The decrease is primarily attributable to $1.7 million in non-recurring expenses during the three and nine month periods ended September 30, 2014 arising from the exploration of various capital raising opportunities.
Advertising and marketing expense: For the three and nine months ended September 30, 2015, the total costs of advertising and marketing increased $288 thousand, or 37.7%, and $894 thousand, or 39.2%, respectively, compared to the same periods in 2014. The primary driver of these increases was the cost of growing brand recognition in newer verticals via advertising and trade show presence.
Occupancy expense: For the three and nine months ended September 30, 2015, total occupancy costs increased $181 thousand, or 34.9%, and $503 thousand, or 36.3%, respectively, compared to the same periods in 2014. The primary driver of the increase in occupancy expense was increased levels of personnel who support loan production and portfolio service.
Data processing expense: For the three and nine months ended September 30, 2015, the total costs associated with data processing and development increased $43 thousand, or 5.9%, and $601 thousand, or 33.6%, respectively, compared to the same periods in 2014. The year to date increase was principally due to the resources dedicated to the build out of the nCino bank operating system platform for Live Oak as well as increased levels of activity in the core system from the substantial growth in loan originations.
Income Tax Expense
Income tax expense for the three and nine months ended September 30, 2015, totaled $2.2 million and $10.3 million, respectively. As a result of the Company’s C corporation status commencing on August 3, 2014, the Company recorded income tax expense of $6.0 million during the three month period ended September 30, 2014 ($3.3 million of which was related to the initial deferred tax liability incurred upon the change from an S to C corporation). The Company has determined that had it been taxed as a C corporation and paid federal income taxes, the federal tax rates would have been approximately 38.5% during 2014. On a pro forma basis, the Company’s federal income tax expense would have been $2.5 million and $5.2 million for three and nine months ended September 30, 2014, respectively. Pro forma net income, after federal taxes for the three and nine months ended September 30, 2014, would have been $4.1 million and $8.3 million, respectively.
Discussion and Analysis of Financial Condition
September 30, 2015 vs. December 31, 2014
Total assets at September 30, 2015 were $1.01 billion, an increase of $339.5 million, or 50.4%, compared to total assets of $673.3 million at December 31, 2014. This increase was due to higher levels of loan originations combined with longer retention times of loans held for sale, comprised largely of loans to newer verticals which require a period of loan advances prior to being sold.
Cash and cash equivalents were $129.9 million at September 30, 2015, an increase of $100.0 million, or 334.4%, compared to $29.9 million at December 31, 2014, primarily as a result of increases in the deposit portfolio and net proceeds of the initial public offering of $87.2 million which closed in July 2015.
Total investment securities increased $2.3 million during the first nine months of 2015, from $49.3 million at December 31, 2014 to $51.6 million at September 30, 2015, an increase of 4.7%. The portfolio is comprised of US government agency securities, residential mortgage-backed securities and a mutual fund.
Loans held for sale increased $148.7 million, or 50.4%, during the first nine months of 2015, from $295.2 million at December 31, 2014 to $443.9 million at September 30, 2015. The increase was primarily the result of new loan originations combined with the aforementioned lengthening of time to sell due to originations of multi-advance loans in newer verticals.
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Loans held for investment increased $55.6 million, or 27.3%, during the first nine months of 2015, from $203.9 million at December 31, 2014 to $259.6 million at September 30, 2015. The increase was primarily the result of new loan originations.
Premises and equipment increased $27.4 million, or 77.6%, during the first nine months of 2015, from $35.3 million at December 31, 2014 to $62.6 million at September 30, 2015. The increase was the result of construction completion on a second building on the Company’s campus in Wilmington, NC.
Servicing assets increased $5.6 million, or 16.0%, during the first nine months of 2015, from $35.0 million at December 31, 2014 to $40.6 million at September 30, 2015. The increase in servicing assets is primarily the result of loan sales during the three quarters of 2015 significantly outpacing the amortization of the existing serviced portfolio and $4.7 million in negative valuation adjustments due to external market conditions (principally isolated to prepayment rates).
At September 30, 2015, the Company did not have any investments in non-consolidated subsidiaries. This is a decrease of $6.3 million from December 31, 2014. During the first quarter of 2015, 100% of the cost method investment in nCino was sold for a gain of $3.8 million and the Company’s ownership in 504FA increased from 50% to 91.3%, resulting in it becoming a consolidated subsidiary with an 8.7% noncontrolling interest held by a third party investor. Transactions during the third quarter of 2015 increased the Company’s ownership of 504FA to 92.4%.
Other assets increased $8.3 million, or 67.1%, during the first nine months of 2015. The increase in other assets is principally comprised of the following 2015 activity: pledged collateral on secured borrowings increased by $4.5 million; accounts receivable increased by $1.6 million related principally to refundable SBA guarantee fees the Bank had paid prior to closing; and accrued interest receivable grew by $1.8 million due to higher levels of loan production.
Total deposits were $762.6 million at September 30, 2015, an increase of $240.5 million, or 46.1%, from $522.1 million at December 31, 2014. The increase in deposits was driven by execution of a deposit growth strategy to support the growth in loan origination.
At September 30, 2015, the Company did not carry a balance of short term borrowings. During the nine month period ended September 30, 2015, the Company’s outstanding $6.1 million short term borrowing from an unaffiliated commercial bank was paid in full.
Shareholders’ equity at September 30, 2015 was $194.1 million as compared to $91.8 million at December 31, 2014. The book value per share was $5.68 at September 30, 2015 and average equity to average assets was 14.2% for the nine months ended September 30, 2015, compared to a book value per share of $3.21 at December 31, 2014 and average equity to average assets of 10.8 % for the year ended December 31, 2014. The change in shareholders’ equity principally represents the proceeds of $87.2 million, net of issue costs, from the initial public offering closed in July 2015, combined with net income to common shareholders for the nine months ended September 30, 2015 of $14.9 million partially offset by $859 thousand in dividends.
Asset Quality
Management considers asset quality to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. This function reports directly to the Audit & Risk Committee of the Board of Directors.
Nonperforming Assets
The Bank places loans on nonaccrual status when they become 90 days past due as to principal or interest payments, or prior to that if management has determined based upon current information available to them that the timely collection of principal or interest is not probable. When a loan is placed on nonaccrual status, any interest previously accrued as income but not actually collected is reversed and recorded as a reduction of loan interest and fee income. Typically, collections of interest and principal received on a nonaccrual loan are applied to the outstanding principal as determined at the time of collection of the loan.
Troubled debt restructurings occur when, because of economic or legal reasons pertaining to the debtor’s financial difficulties, debtors are granted concessions that would not otherwise considered. Such concessions would include, but are not limited to, the transfer of assets or the issuance of equity interests by the debtor to satisfy all or part of the debt, modification of the terms of debt or the substitution or addition of debtor(s).
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The following table provides information with respect to nonperforming assets and troubled debt restructurings at the dates indicated.
Total nonperforming loans (all on nonaccrual)
Total accruing loans past 90 days or more
Total troubled debt restructurings
Less nonaccrual troubled debt restructurings
Total performing troubled debt restructurings
Total nonperforming assets and troubled debt restructurings
Total nonperforming loans to total loans held for investment
Total nonperforming loans to total assets
Total nonperforming assets and troubled debt restructurings to total assets
Total nonperforming loans guaranteed by the SBA (all on nonaccrual)
Total accruing loans past 90 days or more guaranteed by the SBA
Foreclosed assets guaranteed by the SBA
Total troubled debt restructurings guaranteed by the SBA
Less nonaccrual troubled debt restructurings guaranteed by the SBA
Total performing troubled debt restructurings guaranteed by the SBA
Total nonperforming assets and troubled debt restructurings guaranteed by the SBA
Total nonperforming loans not guaranteed by the SBA to total held for investment loans
Total nonperforming loans not guaranteed by the SBA to total assets
Total nonperforming assets and troubled debt restructurings not guaranteed by the SBA to total assets
Total nonperforming assets and troubled debt restructurings at September 30, 2015 were $19.1 million, which represented an $809 thousand, or 4.1%, decrease from December 31, 2014. Total nonperforming assets at September 30, 2015 were comprised of $18.4 million in nonaccrual loans and $48 thousand of foreclosed assets. Of the $18.4 million of nonperforming assets, $15.8 million carried an SBA guarantee, leaving an unguaranteed exposure of $2.6 million in total nonperforming assets at September 30, 2015. The unguaranteed exposure in total nonperforming assets at December 31, 2014 was $3.5 million. Unguaranteed exposure relating to nonperforming assets at September 30, 2015 decreased by $898 thousand, or 25.6%, compared to December 31, 2014.
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As a percentage of the Bank’s total capital, nonperforming loans represented 19.1% at September 30, 2015, compared to nonperforming loans of 30.2% of the Bank’s total capital at December 31, 2014. Adjusting the ratio to include only the unguaranteed portion of nonperforming loans as a percent of the Bank’s total capital to reflect the management’s belief that the greater magnitude of risk resides in the unguaranteed portion of non-performing loans, the ratios at September 30, 2015 and December 31, 2014 were 2.7% and 5.1%, respectively.
As of September 30, 2015, potential problem loans and impaired loans totaled $42.5 million. Risk Grades 5 through 8 represent the spectrum of criticized and impaired loans. Loans in the Veterinary Industry vertical comprise 52.8% of the total potential problem and impaired loans. As of December 31, 2014, potential problem and impaired loans totaled $41.0 million with loans in the Veterinary Industry vertical comprising 56.2% of the total potential problem and impaired loans. The majority of the impaired loans in the Veterinary Industry were originated prior to 2010. The Company believes that its underwriting and credit quality standards have improved as the business has matured. At September 30, 2015, the portion of criticized loans guaranteed by the SBA totaled $21.9 million resulting in unguaranteed exposure risk of $20.6 million, or 8.7% of total held for investment unguaranteed exposure. This compares to total criticized and impaired loans of $41.0 million at December 31, 2014, of which $21.3 million was guaranteed by the SBA.
The Bank does not classify loans that experience insignificant payment delays and payment shortfalls as impaired. The Bank considers an “insignificant period of time” from payment delays to be a period of 90 days or less. The Bank would consider a modification for a customer experiencing what is expected to be a short term event that has temporarily impacted cash flow. This could be due, among other reasons, to illness, weather, impact from a one-time expense, slower than expected start-up, construction issues or other short term issues. In all cases, credit will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan long term. To date, the only types of short term modifications the Bank has given are payment deferral and interest only extensions. The Bank does not alter the rate or lengthen the amortization of the note due to insignificant payment delays. Short term modifications are not classified as troubled debt restructurings, or TDRs, because they do not meet the definition set by the applicable FDIC and accounting standards.
Management endeavors to be proactive in its approach to identify and resolve problem loans and is focused on working with the borrowers and guarantors of these loans to provide loan modifications when warranted. Management implements a proactive approach to identifying and classifying loans as criticized, Risk Grade 5. For example, at September 30, 2015 and December 31, 2014, Risk Grade 5 loans totaled $9.6 million and $9.8 million, respectively. While the level of nonperforming assets fluctuates in response to changing economic and market conditions, the relative size and composition of the loan portfolio, and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio.
Allowance for Loan Losses
The allowance for loan losses (“ALL”), a material estimate which could change significantly in the near-term in the event of rapidly deteriorating credit quality, is established through a provision for loan losses charged to earnings to account for losses that are inherent in the loan portfolio and estimated to occur, and is maintained at a level that management considers appropriate to absorb losses in the loan portfolio. Loan losses are charged against the ALL for loan losses when management believes that the collectability of the principal loan balance is unlikely. Subsequent recoveries, if any, are credited to the ALL for loan losses when received.
Judgment in determining the adequacy of the ALL is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available and as situations and information change.
The ALL for loan losses is evaluated on a monthly basis by management and takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans and current economic conditions and trends that may affect the borrower’s ability to repay.
Estimated credit losses should meet the criteria for accrual of a loss contingency, i.e., a provision to the ALL, set forth in accounting principles generally accepted in the United States of America (“GAAP”). Methodology for
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determining the ALL is generally based on GAAP, the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other regulatory and accounting pronouncements. The ALL is determined by the sum of three separate components: (i) the impaired loan component, which addresses specific reserves for impaired loans; (ii) the general reserve component, which addresses reserves for pools of homogeneous loans; and (iii) an unallocated reserve component (if any) based on management’s judgment and experience. The loan pools and impaired loans are mutually exclusive; any loan that is impaired should be excluded from its homogenous pool for purposes of that pool’s reserve calculation, regardless of the level of impairment.
The ALL of $4.4 million at December 31, 2014 increased by $1.7 million, or 39.6%, to $6.2 million at September 30, 2015. The ALL, as a percentage of loans held for investment, amounted to 2.4% at September 30, 2015 and 2.2% at December 31, 2014. The majority of this increase was in general reserves and was attributed to growth in loans held for investment and expansion into new verticals with higher loss factors due to the Company’s lack of experience in those industries and $250 thousand in charge-offs related to one loan relationship in the Veterinary Industry vertical during the third quarter. General reserves as a percentage of non-impaired loans amounted to 1.79% at September 30, 2015 as compared to 1.52% at December 31, 2014. Net charge-offs were $593 thousand for the nine months ended September 30, 2015, compared to net charge-offs of $557 thousand for the nine months ended September 30, 2014. Annualized net charge-offs in the first nine months of 2015 were 0.13% of average loans, compared to annualized net charge-offs of 0.20% in the same period of 2014.
Actual past due loans have declined, and loan charge-offs have remained relatively stable as management continues to work to improve asset quality. Management believes the ALL of $6.2 million at September 30, 2015 is appropriate in light of the risk inherent in the loan portfolio. Management’s judgments are based on numerous assumptions about current events that it believes to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current ALL or that future increases in the ALL will not be required. No assurance can be given that management’s ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the ALL, thus adversely affecting the Company’s operating results. Additional information on the ALL is presented in Note 5 to the consolidated financial statements included with this report.
Liquidity Management
Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Liquidity is immediately available from four major sources: (a) cash on hand and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) the market value of unpledged investment securities; and (d) availability under lines of credit. At September 30, 2015, the total amount of these four items was $313.4 million, or 30.9% of total assets, an increase of $112.8 million from $200.6 million, or 29.8% of total assets, at December 31, 2014.
Loans and other assets are funded primarily by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and a level amount of brokered deposits have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. Additionally, an investment securities portfolio is available for both immediate and secondary liquidity purposes.
At September 30, 2015, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, and $1.3 million was pledged for secured federal funds lines of credit, leaving $50.4 million available as lendable collateral.
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Contractual Obligations
The following table presents the Company’s significant fixed and determinable contractual obligations by payment date as of September 30, 2015. The payment amounts represent those amounts contractually due to the recipient. The table excludes liabilities recorded where management cannot reasonably estimate the timing of any payments that may be required in connection with these liabilities.
Deposits without stated maturity
Time deposits
Operating lease obligations
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Asset/Liability Management and Interest Rate Sensitivity
One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps. This method, however, addresses only the magnitude of timing differences and does not address earnings or market value. Therefore, management uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios to more accurately measure interest rate risk.
The balance sheet is slightly liability-sensitive with a total cumulative gap position of -1.44% at September 30, 2015. Through the first half of 2015, the flat rate environment led to extension of longer term fixed rate deposits to more closely align with the term of fixed rate agriculture loans. A liability-sensitive position means that net interest income will generally move in the opposite direction as interest rates. For instance, if interest rates increase, net interest income can be expected to decrease, and if interest rates decrease, net interest income can be expected to increase. The Company attempts to mitigate interest rate risk with the majority of assets and liabilities being short-term, adjustable rate instruments. The quarterly revaluation adjustment to the servicing asset, however, adjusts in an opposite direction to interest rate changes. Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes and the longer duration of indeterminate term deposits.
Capital
The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis. The Company’s principal goals related to the maintenance of capital are to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; provide financial flexibility to support future growth and client needs; comply with relevant laws, regulations, and supervisory guidance; achieve optimal credit ratings for the Company and its subsidiaries; and provide a competitive return to shareholders. Management regularly monitors the capital position of the Company on both a consolidated and bank level basis. In this regard, management’s goal is to maintain capital at levels that are in excess of the regulatory “well capitalized” levels. Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.
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Capital amounts and ratios as of September 30, 2015 and December 31, 2014, are presented in the table below.
Consolidated – September 30, 2015
Common Equity Tier I (to Risk-Weighted Assets)
Total Capital (to Risk-Weighted Assets)
Tier I Capital (to Risk-Weighted Assets)
Tier I Capital (to Average Assets)
Bank - September 30, 2015
Consolidated - December 31, 2014
Bank - December 31, 2014
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Accounting policies, as described in detail in the notes to the Company’s consolidated financial statements, are an integral part of the Company’s financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. Management believes that the critical accounting policies and estimates listed below require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain.
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Changes in these estimates, that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, would have a material impact on the Company’s financial position, results of operations or liquidity.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Management considers interest rate risk the most significant market risk. Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. Consistency of net interest income is largely dependent upon the effective management of interest rate risk.
The Company’s Asset/Liability Management Committee (“ALCO”), which includes senior management representatives and reports to the Board of Directors, monitors and manages interest rate risk. See “Asset/Liability Management and Interest Rate Sensitivity” in Item 2 of this Form 10-Q for further discussion.
The objective of asset/liability management is the maximization of net interest income within the Company’s risk guidelines. This objective is accomplished through management of the balance sheet composition, maturities, liquidity, and interest rate risk exposures arising from changing economic conditions, interest rates and customer preferences.
To identify and manage its interest rate risk, the Company employs an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on contractual cash flows and repricing characteristics and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes management projections for activity levels in each of the product lines offered by the Bank. Assumptions are inherently uncertain and the measurement of net interest income or the impact of rate fluctuations on net interest income cannot be precisely predicted. Actual results may differ materially from simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), was carried out under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer as of September 30, 2015, the last day of the period covered by this Quarterly Report. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of September 30, 2015 in ensuring that the information required to be disclosed in the reports the Company files or submits under the Exchange Act is (i) accumulated and communicated to management (including the Company’s Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control Over Financial Reporting
Management has not evaluated any changes in the Company’s internal control over financial reporting that occurred during the quarterly period ended September 30, 2015 due to a transition period established by the rules of the Securities and Exchange Commission for newly public companies.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In the ordinary course of operations, the Company is party to various legal proceedings. The Company is not involved in, nor has it terminated during the three or nine months ended September 30, 2015, any pending legal proceedings other than routine, nonmaterial proceedings occurring in the ordinary course of business.
Item 1A. Risk Factors
There have been no material changes to the risk factors that have been previously disclosed in the Company’s registration statement on Form S-1 (File No. 333-205126), as amended, filed with the SEC.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On July 22, 2015, the Securities and Exchange Commission (the “SEC”) declared effective the Company’s registration statement on Form S-1 (File No. 333-205126), as amended, filed in connection with the initial public offering of the Company’s common stock. Pursuant to the Registration Statement and to a Rule 462(b) Registration Statement filed on July 23, 2015 (File No. 333-205805), the Company registered the offer and sale of 5,500,000 shares of voting common stock with an aggregate offering price of approximately $93.5 million. On July 28, 2015, the Company issued and sold 4,800,000 shares of voting common stock at a price to the public of $17.00 per share (the “Offering”). Sandler O’Neill & Partners, L.P.; Keefe, Bruyette & Woods, Inc.; and SunTrust Robinson Humphrey, Inc. acted as joint book-running managers for the Offering. On July 29, 2015, the underwriters exercised their option to purchase additional shares pursuant to the underwriting agreement (the “Over-Allotment Option”). On July 31, 2015, the Company closed the Over-Allotment Option, and sold 700,000 shares at a price to the public of $17.00 per share.
As a result of the Offering and the Over-Allotment Option, the Company received net proceeds of approximately $87.2 million in the aggregate, which consists of gross proceeds of $93.5 million, offset by underwriting discounts and commissions of approximately $4.9 million and other offering expenses of approximately $1.5 million. No payments for such expenses were made directly or indirectly to (i) any of the Company’s officers or directors or their associates, (ii) any persons owning 10% or more of any class of the Company’s equity securities or (iii) any of the Company’s affiliates. The Offering and the Over-Allotment Option terminated after all registered securities had been sold.
Of the net proceeds of approximately $87.2 million from the initial public offering, $12.2 million has been deployed to curtail corporate borrowings with the remainder deposited into the Bank for further debt repayment and utilization in strategic growth and initiatives. There has been no material change in the expected use of the net proceeds from the initial public offering as described in the final prospectus, dated July 23, 2015, filed with the SEC pursuant to Rule 424(b) relating to the Company’s registration statement on Form S-1 (File No. 333-205126), as amended.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not Applicable
Item 5. Other Information
None
Item 6. Exhibits
Exhibits to this report are listed in the Index to Exhibits section of this report.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ S. Brett Caines
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INDEX TO EXHIBITS
ExhibitNo.
Description of Exhibit