Description

Situation Overview

We believe shares in Live Oak Banchshares, a North Carolina-based bank focused on small business lending, represent one of the most compelling banking short opportunities that we’ve seen in recent years. From a lofty starting valuation approaching 6.5x tangible book value (versus a peer average of 1.9x), we see 60% downside as several one-time tailwinds fall away.

It’s no secret that the market has become enamored with anything “fintech” related over the last year.  Amidst this broad investor excitement, we believe the market has wrongly swept up shares in Live Oak, a bank that before COVID was generating an underwhelming return on equity (mid-single digits) and was trading at roughly 1.3x book value.  Unlike many banks, COVID proved hugely beneficial to Live Oak as it was able to generate windfall earnings from the government’s Paycheck Protection Program (“PPP”), which are now flowing through current year financials.  At the same time that its loan originations took off from PPP, a former Live Oak subsidiary called nCino, which Live Oak had spun off in 2014, completed a very successful initial public offering, nearly tripling on its first day of trading.  Between the loose association with a popular SaaS IPO and PPP-driven growth, investors appear to have confused Live Oak as a fintech play, driving the stock to $97 per share, almost 400% above its pre-COVID share price of ~$20.  Adding fuel to the fire, management has put their foot on the gas with new loan originations this year hoping to plug the PPP hole through blistering loan growth (+52% origination growth year-to-date).  While this strategy seems to be working in a favorable credit environment, we question the rationale for managing earnings by grossing up the balance sheet to such a large degree, especially if the credit environment turns.

Even without any macro risks materializing, we see significant downside from such a high starting valuation for a bank that is generating a teens core ROE and facing flat-to-down earnings over the next several years as several one-off’s normalize.  To highlight the absurdity of the situation, at its current market cap of $4.3 billion, LOB’s market cap is equal to more than 50% of its total assets.

Company Background

Founded in 2008, Live Oak rapidly gained share over the last decade in the Small Business Administration (“SBA”) lending program.  The SBA program provides a government guarantee for 75% of a loan’s value to incentivize lending to small businesses.  While many banks offer SBA loans, few have chosen to prioritize what is generally viewed as a lower profitability product given the high administrative burden for an average loan measuring in the hundreds of thousands of dollars with a fixed interest rate.  In contrast, Live Oak seems to have focused on the upper-end of the SBA program targeting multi-million dollar loans that we estimate have a roughly comparable cost to serve as lower-value loans.  Moreover, Live Oak’s original business model was to serve as an originator, quickly flipping most of the SBA loans that it placed, resulting in a capital light, gain-on-sale driven business that generated high returns on equity.  However, starting a few years ago, the company began holding more of the loans on balance sheet, which has negatively impacted the bank’s returns on equity (we believe this was likely driven at least in part to avoid regulatory pushback on the company).

Then COVID hit, and the SBA ended up as the administrator for PPP.  As the largest SBA lender, Live Oak was in the pole position to benefit from this program.  In 2020, Live Oak originated $1.8 billion of PPP loans compared to an existing loan book of just $2.6 billion.  With the accelerated recognition of revenue from PPP loans as they are forgiven, Live Oak’s net income has more than tripled.  A bank that had struggled to hit a double-digit return on equity has been regularly posting quarters with a return on equity in excess of 20%.

Why Live Oak is a Short

PPP Loans Running Off:  For background, banks generate a small amount of net interest income from PPP loans (1% interest rate) but then also receive a larger processing fee (3%+) which is amortized over the life of the loan. However, as PPP loans are forgiven, banks recognize the full amount of the deferred fee creating a lumpy earnings stream. >70% of PPP loans have run off over the last year with the remainder set to fall away in the coming quarters.  With the large amount of forgiveness, we estimate that PPP has accounted for over one-third of earnings over the last year.  As PPP disappears, we think the market will more clearly see the teens ROE core bank which has been hidden behind an average 27% headline ROE over the last year.

Elevated Gain on Sale:  Although Live Oak shifted to keeping more loans on balance sheet a few years ago, the company continues to derive a large amount of its profits from loan sales.  This past quarter, gains on loans sold amounted to roughly 60% of core pre-tax income by our estimate after management sold nearly 50% more loans in the quarter compared to the recent run-rate. We would emphasize that this gain-on-sale earnings stream is lower quality given its non-recurring and volatile nature. While not directly comparable, “disruptive” mortgage originators still trade at ~10x earnings in part due to the gain-on-sale driven business model. This is a far cry from Live Oak trading at nearly 40x earnings. 

Increased Credit Cost Going Forward:  In recent years, Live Oak’s origination mix has begun to shift from government guaranteed programs (SBA and USDA) to conventional small business loans. Conventional loans now account for nearly 40% of Live Oak loans and are growing fast.  While Live Oak has carved out an interesting niche in the jumbo end of the SBA market ($1.5 million average loan size versus $700k average for the program), we question how much more runway there is for this strategy, especially before regulators take notice.  As Live Oak transitions to focus increasingly on conventional small business loans, we suspect this will come at the cost of higher expenses and credit costs over time. Put simply, >50% loan growth from relatively new “specialty” verticals (e.g., sponsor finance, bioenergy) seems unlikely to end well. As an example, a 1 percentage point provision ratio (versus ~30 bps annualized year-to-date) would equate to a greater than $0.60 earnings headwind, which would represent over 20% of 2021 estimated core earnings.  

Fintech Investments Unlikely to Move the Needle:  Following the nCino IPO last year, some investors appear to have mistaken Live Oak as a fintech play.  In 2012, Live Oak incubated nCino, a SaaS offering for banks built on top of Salesforce software, before spinning it off prior to Live Oak’s own IPO in 2015.  As a result, current Live Oak shareholders saw no benefit from the nCino IPO, which came public at a hefty valuation of more than 40x revenue and eclipsed Live Oak’s own market cap by a large margin.  While Live Oak does currently have a portfolio of 8 direct fintech investments, we believe these are unlikely to prove material to Live Oak’s valuation.  For context, the investment portfolio is currently carried at a little over $100 million with an estimated implied valuation based on most recent marks at $183 million (<5% of Live Oak’s market cap).

Unforgiving Valuation for a Balance Sheet Financial:  While we are sympathetic to the argument for the capital-light disrupters to trade at premium valuations, we take exception to a capital-intensive small business lender with unremarkable returns on equity trading at nearly 6.5x tangible book due to a loan growth story that has not been tested in even average credit conditions.  Even setting aside book value as a benchmark, we estimate that Live Oak will generate just over $2.50 of core earnings next year as PPP falls away and other tailwinds normalize, leaving the stock at ~40x our estimate of 2022 earnings.

Assuming a multiple of 15x forward earnings (a premium to the current US bank average of 14x) would imply a target price of $38, representing over 60% downside from current levels.  Moreover, at that valuation, Live Oak would still be trading at 2x tangible book value.

Catalyst

• Roll-off of PPP
• Reduced gain-on-sale
• Normalized credit costs