Live Oak Bancshares: Exciting Model, But Near-Term Risks (NASDAQ:LOB)

There’s a lot to like about Live Oak Bancshares (NASDAQ:LOB) for the long term. Banks with high-touch service models and differentiated lending specialties typically do better than average, and Live Oak’s embrace of technology-enabled banking could be a major differentiator over time. In the short term, though, I’m concerned about owning a liability-sensitive bank during a period of Fed tightening, not to mention a bank heavily leveraged to small business lending when the economy is cooling.

Valuation is interesting. My long-term discounted cash flow model suggests exciting double-digit long-term annualized total return potential, but short-term multiples-based approaches (ROTCE-driven P/TBV and P/E) are much less accommodating, with the shares trading at a premium during a period where many other growth banks (East West (EWBC), Signature Bank (SBNY), and SVB Financial (SIVB) among others) are trading at high single-digit forward P/E’s.

A Provision-Driven Miss, With Strong Pre-Provision Results

Live Oak’s reported core earnings per share were weaker than expected (by about $0.03/share) in a quarter where most smaller banks beat expectations, but the results were considerably better at the pre-provision level, and given Live Oak’s historical credit quality, I’m not concerned about the higher provisioning (particularly given strong loan growth).

Revenue rose 12% year over year and 11% quarter over quarter on a core adjusted basis. Net interest income rose 26% yoy and 5% qoq, beating expectations by about 1%, or $0.015/share. Net interest margin declined 15bp yoy and 5bp qoq to 3.84%, about 10bp better than expected, while earning assets grew 5% qoq. Adjusted net interest income rose 32% qoq, beating by 24% and driving about $0.11/share of upside.

Operating expenses rose 30% yoy and 6% and came in a bit higher than expected, but still beat on an efficiency ratio basis (65.7% vs. 69.2%). Pre-provision profits fell 12% and rose 21% qoq, beating by close to 20%, or $0.12/share. Provisioning took $0.20/share out of earnings relative to expectations, but Live Oak also saw a much lower tax rate in the quarter.

Healthy Loan Demand… But The Cost Of Funds Is A Key Watch Item

Live Oak once again delivered strong loan growth, with adjusted end-of-period loans up 23% yoy and 18% qoq on strong demand for small business C&I and real estate loans. Originations rose 5% sequentially ($1 billion versus an end-of-period $6.8B in net loans), while yield improved 62bp yoy and 45bp qoq to 5.91% on a core basis. Almost half (48%) of loan originations were SBA loans.

Deposits rose 23% yoy and 3% qoq, with non-interest-bearing deposits up 121% yoy and 43% qoq. Interest-bearing deposits cost rose 57bp to 1.55%, while total deposit costs rose 57bp to 1.53%.

Live Oak doesn’t operate a traditional branch structure, and its deposit-gathering is done through the internet. Non-interest-bearing deposits are a trivial portion of total deposits, and Live Oak has to compete aggressively for deposits – while there are some banks paying more for CDs (Ally Financial (ALLY) and Capital One (COF) among them), Live Oak is right up there at 3.75% on one-year CDs as of this writing.

This is my biggest near-term concern about Live Oak. Lacking a core deposit franchise, Live Oak is liability-sensitive, meaning that its net interest margin is expected to shrink as interest rates rise. The bank did outperform this quarter, and management did guide to the high end of its NIM range for the fourth quarter, but I’ve been pretty consistent in predicting higher-than-expected deposit betas for this cycle, and I think Live Oak could have some vulnerability here.

I’m also a little concerned about near term for loans. Live Oak has built its business around small business lending to specialty verticals through a high-touch model, but I’m concerned about the risk of weaker loan demand over the next 12-18 months as companies deal with higher rates and greater uncertainty about the economy.

To be very clear, though, this is a short-term concern. Longer term, I think small business lending is an attractive market for Live Oak, as many large banks don’t handle small business customers particularly well and small banks struggle to compete on service quality. I love the company’s high-touch model (a model used successfully by companies like First Republic (FRC) and Pinnacle (PNFP)), as well as the company’s ongoing efforts to expand technology-enabled banking, including embedding banking functionality into ERP software packages used within its targeted specialty verticals.

The Outlook

I don’t worry about credit quality here. Over 40% of the bank’s loans are guaranteed by government organizations like the SBA, and since 2012 the bank has an accumulated total of $56M net charge-offs against $19.6B in loan originations. Given that backdrop, I think the bank’s 1.2% reserve position is fine, and I’m not concerned about credit quality or capital adequacy here.

As the bank grows, it is likely to outgrow what SBA lending can provide, but by building these specialty verticals, the bank should be well-placed to expand into more conventional C&I and CRE lending without too much trouble. What’s more, I believe technology-enabled banking is going to become the norm, and that’s going to make life difficult for smaller banks that lack Live Oak’s understanding of fintech and the capabilities it has gained through fintech partnerships.

I expect double-digit long-term core earnings growth from Live Oak, and managing that growth will create challenges for the bank, but I also use a higher discount rate here than I would for First Republic or a more conventional bank like PNC Financial (PNC).

The Bottom Line

Live Oak shares have underperformed dramatically over the past year, with the market bailing out of both growth and liability-sensitive names. Even with that underperformance, though, the valuation call is complicated. If my long-term core earnings model is accurate, and Live Oak can generate long-term core earnings growth in the low double-digits and with low double-digit ROEs, these shares should generate an attractive mid-teens long-term annualized return. On the other hand, accurately modeling interest rates out beyond a year or two is exceptionally difficult, not to mention other bank income line items.

Shorter-term approaches aren’t as accommodating. Near-term ROTCE in the 12% to 13% range only gets me to around the current share price on a P/TBV basis, and while a forward of P/E of 13x on my FY’23 EPS estimate isn’t bad relative to the growth, many growth banks are now trading at single-digit forward P/E’s. I could argue that Live Oak should trade closer to $40, but sentiment for banks is weak now, and it’s harder to argue for a premium for a liability-sensitive small business lender in a tightening cycle.

Investors willing to accept and look past the near-term risks that Live Oak’s spread income could underperform on higher-than-expected deposit costs and that sentiment could worsen further may like what they find here. At a minimum, I think this is a name to keep on a watchlist, but I think it may be early to establish a full position.