Live Oak Stock: Watch Short-Term Loan Growth

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Overview

Live Oak (LOB) is the largest lender in the SBA 7(a) lending space. Over the past five years, the bank has solidified its leadership position in the SBA loan rankings. Beginning in FY21, Live Oak surpassed the second-largest SBA lender by $1.4 billion. Additionally, Live Oak is bigger than Huntington (HBAN), Newtek (NEWT) and Celtic combined. An additional observation is that monetary central banks such as JP Morgan (JPM), Wells Fargo (WFC), US (USB) Bank showed lower approved dollars and started to exit the market. As such, over the long term, investors should expect continued execution and penetration into the SBA lending space. Success in space is a testament to management’s focus and ability to execute.

Market share of Live Oak Bancshares

Q3 IR board

From a loan origination perspective, the bank recorded a second consecutive quarter of $1 billion in origination during the third quarter of 2021. The management team reports that the fully funded origination of the SBA loan, to some extent, mitigates the PPP loan run-off. While the jury is still out on this, it would be hard to imagine Prospective Economic Development being robust enough to support around $500 million in loans. A good aspect of making PPP loans is exposing borrowers to Live Oak and providing organic relationship building. A simple comparison would show the pre-COVID loan portfolio of $2.6 billion as of the year 2019. Expect loan issuance at a deficit-mitigating rate of about $3 billion (compared to $5.5 billion in the Q3 2021 loan portfolio) would be a long way off. Although the calculations may be wrong or overly simplistic, the conclusion will likely be the same.

Fintech investment

Another potential reason for investor enthusiasm for the bank was its success in fintech incubation. Since GreenLight tagged one of Canapi Venture’s portfolios at $2.3 billion, the valuation of the fintech incubation has reached a total of around $183 million. While the success of fintech valuation is exciting, the unknown is whether these valuation levels will be sustainable and whether the company’s growth will be sufficient to sustain a rise in the future. In the meantime, the latest market talk of rising interest rates would likely be negative from a valuation perspective, as the cost of capital may be higher and investors will value short-dated assets more than venture capital investments with an uncertain timeline. All in all, the venture capital portfolio is subject to a considerable amount of risk. With a current valuation of $3.7 billion in market capitalization, the main business is essentially valued at $3.5 billion, or about 95% of current market capitalization.

Transaction Review

From a profitability perspective, ROE and ROA have fluctuated significantly over time. The credit quality of the loan portfolio has improved, but non-performing loans as a percentage of total clean are still relatively high compared to their peers. The net interest margin has tended to decline over time, largely reflecting the interest rate environment in which the bank operates.

The silver lining is the significant growth in the loan portfolio over time, with the total loan portfolio growing from approximately $900 million in fiscal year 2016 to $2.6 billion in fiscal year 2019. , a CAGR of approximately 42%. Going forward, given the fragmentation of the SBA loan market, investors should expect Live Oak to continue to drive success in the SBA loan market, although we do not whether growth in traditional loan portfolios will be enough to offset the liquidation of PPP loans.

Live Oak Bancshares Finance

CapIQ, 10K

Evaluation

The current valuation of 22x P/E and 5.3x P/TBV is rich compared to its peers. LOB has always enjoyed a higher valuation given its leading position in the SBA home loan market as well as the success of fintech incubation. The current valuation looks rich and investors should expect perfect execution by the management team to support its current valuation.

Valuation of LOB stocks

CapIQ, 10K

Risk/Reward

From a risk perspective, the liquidation of PPP loans would create a “hole” in the current portfolio. The bank should work very hard to fill the hole left by the PPP loan. Additionally, a higher interest rate could have a negative impact on the valuation of Live Oak’s portfolio.

From a rewards perspective, the bank will likely continue to grow its SBA lending practice. Ranked #1 in dollars approved for the past four consecutive years, the bank has earned a reputation as a relationship bank with small businesses that meet its criteria. A PPP loan was made when acquiring an organic relationship for Live Oak and we expect the bank to take advantage of the “free publicity” to expand its program. Additionally, a rising rate environment would benefit Live Oak, helping the bank reprice its loan portfolio and improve spread income profitability.

Conclusion

In summary, the current valuation poses a significant risk to the stock price. While we continue to like management execution and the bank’s fundamental trajectory, we struggle to justify the valuation. The PPP loan run-off displayed significant earnings risk that may result in a retrade of the stock. Additionally, while a higher rate environment is beneficial for NIM’s expansion, it will hurt long-term assets, such as Live Oak’s venture capital portfolio, in terms of valuation. We plan to continue to monitor loan growth for Live Oak and once the growth trajectory returns to a normal pace, we would be an interested investor. In the short term, the risk-reward ratio is such that we are more bearish than neutral.

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