Live Oak Bancshares, Inc. 2026 Q3 Earnings Call

Good morning, everyone. Welcome to Live Oak's third quarter 2026 earnings conference call. We are webcasting live over the internet, and this call is being recorded. To access the call over the internet and review the presentation materials that we will reference on the call, please visit our website at investor.liveoak.bank and go to the events and presentations tab for supporting materials. Our earnings release is also available on our website. Before we get started, I'd like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call.

Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials. Here in the room, we have Chip Mahan, our Chairman and CEO, and Michael Cairns, our Chief Credit Officer, who will be available for Q&A after our President, BJ Losch, and CFO, Walt Phifer, finish their prepared remarks. I'll now turn over the call to BJ.

Great. Thanks, Greg. Good morning, everybody. Let me start where you'd expect me to start. We reported EPS at $0.52, as obviously not the number we wanted to print and not the number you expected from us. The driver was $17 million of additional provision on our exited distillery portfolio, about $0.27 of EPS. Excluding that action, adjusted EPS was $0.76. Later on, Walt will walk you through that bridge on slide 15. I'll spend time right up front on that this morning, but then I'm going to spend quality time on what is at risk of getting lost this quarter, which is our operating performance and momentum underneath these results, which is simply outstanding, one of the strongest operating quarters in our company history. Let's get started on slide 4. Five themes in the quarter. One, the decisive action on the distillery portfolio.

Two, outstanding operating leverage momentum with record adjusted PPNR of $88 million, up 33% year-over-year. Three, the main Live Oak engine, our small business banking model, is humming. Four, Live Oak Express and business checking are now generating meaningful profit and have a long runway ahead. Five, deploying AI is front and center for us, and our adoption continues to accelerate. We've only scratched the surface of what's possible. First of those five is about actively dealing with a challenge head-on, which is who we are, and the others are about continuing to build a company with strong, sustainable operating earnings and growth. Overall provision this quarter was $55 million. Four pieces, and they shouldn't be looked at the same way, and you can see that on slide 5. First, $17 million or 31% on the exited distillery portfolio. More on that in a moment.

Second, $16 million or 30% of the total from loan growth. We added more than $700 million of loan balance growth this quarter, a record. As I've said before, CECL is not kind to growing companies like ours. That $16 million is a reserve against loans we haven't had a chance to earn a penny on yet. I'll take that trade over low growth and lower provision all day, every day. Third, $13 million or 24% of the provisioning was in commercial banking from six relationships across three verticals, not concentrated. Since these are larger loans, we will see more of a mix of impairments, charge-offs, and recoveries in any given quarter, making results more lumpy. Fourth, $9 million or 16% of provisioning was in small business, where it was diversified with no single industry driving it and consistent with the history of our book.

Turning to slide 6 on distillery. As we talked about last quarter, we exited this vertical in 2024, over two years ago, and we're at workout only. While eight of the 13 loans are still accruing, we have 98% of the portfolio classified and have dedicated workout resources for all of them, with every remaining loan under enhanced monitoring. What happened industry-wide is pretty straightforward if you read the news. Second straight year of declining U.S. spirits demand, resulting in further excess barrel inventory across the industry, which is driving a sharp decline in collateral values. We've now recognized $29 million of provision year to date on this portfolio through specific reserves and net charge-offs. That portfolio is about one-half of 1% of our total loan book. So of course, this hurts, but it's manageable given our PPNR strength.

We have a saying at Live Oak that when you have to eat something unpleasant, you don't take small bites, and that's exactly what we've done here. Every quarter, we've taken every charge and every impairment we could reasonably support as soon as we could support it. We have not spread this out to smooth the quarter, and we're not going to with this or any challenge we have. From here, what we watch is collateral realization versus our current estimates, ongoing performance of those businesses, and active cooperation from our borrowers. We've been proactive with each relationship and exposure and will continue to be. We've made significant progress working the book in the last six months. We'll continue to be transparent as we work through the rest of the exposures.

Now turning to slide 7, let's move beyond the distillery noise and look at the fantastic operating earnings, which are outstanding. Adjusted revenue grew 15% year-over-year to $172 million, while adjusted expenses grew only 1%. 15 and 1. 15x operating leverage. That produced record adjusted PPNR of $88 million, up 33% from a year ago and 16% from just last quarter, with our adjusted efficiency ratio improving 7 points year-over-year from 56% to 49%. We've built an operating model that produces $88 million of pre-provision earnings a quarter and growing. That's the number that matters most to me because it is the number that allows us to absorb actions like we did this quarter. On that last point, slide 8 demonstrates just how much we have improved the business over the last 2 years. Go back 2 years to the third quarter of 2024.

Adjusted PPNR was $53 million. Today, it's $88 million, up 64%. Adjusted revenue is up 31% over that stretch, while expenses are up 9%. Over 3x operating leverage. Total assets are up 35%. Now, look at the provision. Q3 2024, we took $35 million in provision and delivered $19 million of adjusted pre-tax income. This quarter, we took $55 million, $20 million more, and still delivered $33 million of pre-tax income. That is 74% more pre-tax income in just 2 years while absorbing substantially more provision. Excluding distillery was $50 million, 163% above where we were just 2 years ago. That's excellent operating leverage, and it earns us the flexibility to deal with the problem and keep momentum moving forward. Flexibility we did not have 2 years ago.

It is the reason we can take the big bite and still earn money, still grow 16%, and still fund every initiative that matters to us. Turning to slide 9, the biggest driver of that performance continues to be our small business franchise, the engine of this company. We are the number 1 SBA lender in the country by dollar amount again, and it's not even close. Our deep expertise across 30 verticals, along with an unmatched speed and quality of execution is why. The business is clearly demonstrating soundness and profitability along with that growth. Our default performance continues to significantly outperform the broader SBA industry. This is a portfolio we have underwritten through multiple cycles and is doing exactly what we expect it to do. A key initiative to extend our SBA scope is on slide 10.

Live Oak Express, our small dollar SBA 7(a) business, posted another record with $107 million of originations, up 173% from a year ago and up from $82 million last quarter. This is a fee-generating, capital-efficient engine for us. We sell more than 75% of the guaranteed portion at strong gain on sale premiums, which recycles liquidity. We earn servicing fees, and we retain the roughly 25% unguaranteed portion on the balance sheet, which earns recurring net interest income. Gain on sale from Express was $7 million this quarter, up 250% year-over-year. We've now generated $18 million over the last 5 quarters, about $0.30 of earnings accretion and growing. This is just fantastic work by our Live Oak Express team and everyone involved. Our target at cruise altitude remains over $750 million annually in this business.

And again, do the math on that kind of volume at those premiums. The earnings impact still in front of us is substantial. Turning to slide 11, our second key initiative, growing checking to deepen relationships and lower our funding costs. Checking balances crossed a half a billion dollars this quarter, up 39% year-over-year, with total relationship deposits at now $1.3 billion. Why it matters is cost and stickiness. Our relationship deposit base only costs us 184 basis points compared with our overall deposit cost of 347. And the relationship depth keeps building. 25% of our customers now have both a loan and deposit account, up from 20% a year ago, and four years ago, that number was only 3%. We're at roughly 5% of checking and DDA to total deposits, with our target at 10% and above.

On a deposit base of about $15.5 billion growing 16% a year, that is an enormous amount of funding improvement still ahead of us. Phenomenal work by our lenders and our treasury management teams, and there's a lot more to come. Moving to slide 12, our AI efforts continue to accelerate. 100% of our employees have access to AI native tools, and we now have 200 Claude super users across the company with a bank-wide rollout of Claude for Enterprise kicking off this fall, which will unlock even more capabilities. Our people are building real things, as you can see on the bottom left. But we have been smart about it, building common skills and prompts and requiring training while also encouraging innovation. I'd point you to the credit side of that list on purpose.