Edgar Filing: Live Oak Bancshares, Inc.

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SEC Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q



ý	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2016



¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to .

Commission file number: 001-37497

LIVE OAK BANCSHARES, INC.

(Exact name of registrant as specified in its charter)



North Carolina	26-4596286
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1741 Tiburon Drive Wilmington, North Carolina	28403
(Address of principal executive offices)	(Zip Code)

(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 ý 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 ý 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 definitions 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 ý

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 May 11, 2016, there were 29,467,643 shares of the registrant’s voting common stock outstanding and 4,723,530 shares of the registrant’s non-voting common stock outstanding.

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Live Oak Bancshares, Inc. and Subsidiaries

Form 10-Q

For the Quarterly Period Ended March 31, 2016

TABLE OF CONTENTS



		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)	1
	Consolidated Balance Sheets as of March 31, 2016 and December 31, 2015	1
	Consolidated Statements of Income for the Three Months Ended March 31, 2016 and 2015	2
	Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2016 and 2015	3
	Consolidated Statements of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2016 and 2015	4
	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015	5
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	47
Item 4.	Controls and Procedures	47
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	48
Item 1A.	Risk Factors	48
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	48
Item 3.	Defaults Upon Senior Securities	48
Item 4.	Mine Safety Disclosures	48
Item 5.	Other Information	48
Item 6.	Exhibits	48
	Signatures	49
	Index to Exhibits	50

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Live Oak Bancshares, Inc.

Consolidated Balance Sheets

As of March 31, 2016 (unaudited) and December 31, 2015*

(Dollars in thousands)



	March 31, 2016			December 31, 2015*
Assets
Cash and due from banks	$	226,556		$	102,607
Certificates of deposit with other banks	9,000			10,250
Investment securities available-for-sale	55,674			53,762
Loans held for sale	537,293			480,619
Loans held for investment	313,633			279,969
Allowance for loan losses	(8,616		)	(7,415		)
Net loans	305,017			272,554
Premises and equipment, net	61,839			62,653
Foreclosed assets	3,020			2,666
Servicing assets	47,377			44,230
Other assets	22,765			23,281
Total assets	$	1,268,541		$	1,052,622
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing	$	21,125		$	21,502
Interest-bearing	994,340			783,286
Total deposits	1,015,465			804,788
Long term borrowings	28,271			28,375
Other liabilities	20,372			19,971
Total liabilities	1,064,108			853,134
Shareholders’ equity
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding at March 31, 2016 and December 31, 2015	—			—
Class A common stock, no par value, 100,000,000 shares authorized, 29,460,348 and 29,449,369 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively	138,199			137,492
Class B common stock, no par value, 10,000,000 shares authorized, 4,723,530 shares issued and outstanding at March 31, 2016 and December 31, 2015	50,015			50,015
Retained earnings	16,147			12,140
Accumulated other comprehensive income (loss)	47			(192		)
Total shareholders’ equity attributed to Live Oak Bancshares, Inc.	204,408			199,455
Noncontrolling interest	25			33
Total equity	204,433			199,488
Total liabilities and shareholders’ equity	$	1,268,541		$	1,052,622

* Derived from audited consolidated financial statements.

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Income

For the three months ended March 31, 2016 and 2015 (unaudited)

(Dollars in thousands, except per share data)



	Three Months Ended March 31,
	2016		2015
Interest income
Loans and fees on loans	$	11,005	$	6,730
Investment securities, taxable	251		176
Other interest earning assets	138		66
Total interest income	11,394		6,972
Interest expense
Deposits	2,444		1,476
Borrowings	241		441
Total interest expense	2,685		1,917
Net interest income	8,709		5,055
Provision for loan losses	1,433		1,077
Net interest income after provision for loan losses	7,276		3,978
Noninterest income
Loan servicing revenue and revaluation	4,758		4,106
Net gains on sales of loans	16,425		15,461
Equity in loss of non-consolidated affiliates	—		(26		)
Gain on sale of investment in non-consolidated affiliate	—		3,782
Construction supervision fee income	630		216
Other noninterest income	619		516
Total noninterest income	22,432		24,055
Noninterest expense
Salaries and employee benefits	12,993		8,355
Travel expense	1,846		1,476
Professional services expense	528		850
Advertising and marketing expense	963		1,008
Occupancy expense	1,193		481
Data processing expense	1,208		893
Equipment expense	551		443
Other loan origination and maintenance expense	574		477
Other expense	1,855		719
Total noninterest expense	21,711		14,702
Income before taxes	7,997		13,331
Income tax expense	3,314		5,278
Net income	4,683		8,053
Net loss attributable to noncontrolling interest	8		20
Net income attributable to Live Oak Bancshares, Inc.	$	4,691	$	8,073
Basic earnings per share	$	0.14	$	0.28
Diluted earnings per share	$	0.13	$	0.27

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Comprehensive Income

For the three months ended March 31, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Three Months Ended March 31,
	2016			2015
Net income	$	4,683		$	8,053
Other comprehensive income before tax:
Net unrealized gain on investment securities arising during the period	389			203
Reclassification adjustment for (gain) loss on sale of securities available-for-sale included in net income	—			—
Other comprehensive income before tax	389			203
Income tax expense	(150		)	(79		)
Other comprehensive income, net of tax	239			124
Total comprehensive income	$	4,922		$	8,177

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

For the three months ended March 31, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Common stock				Retained earnings (accumulated deficit)			Accumulated other comprehensive income (loss)			Non- controlling interest			Total equity
	Shares
	Class A	Class B	Amount
Balance at December 31, 2014	23,896,400	4,723,530	$	98,672	$	(6,943	)	$	85		$	—		$	91,814
Net income (loss)	—	—	—		8,073			—			(20		)	8,053
Other comprehensive income	—	—	—		—			124			—			124
Consolidation of investment with non-controlling interest	—	—	—		—			—			35			35
Stock option exercises	3,679	—	16		—			—			—			16
Stock option based compensation expense	—	—	118		—			—			—			118
Restricted stock expense	—	—	8		—			—			—			8
Balance at March 31, 2015	23,900,079	4,723,530	$	98,814	$	1,130		$	209		$	15		$	100,168
Balance at December 31, 2015	29,449,369	4,723,530	$	187,507	$	12,140		$	(192	)	$	33		$	199,488
Net income (loss)	—	—	—		4,691			—			(8		)	4,683
Other comprehensive income	—	—	—		—			239			—			239
Issuance of restricted stock	2,776	—	—		—			—			—			—
Stock option exercises	8,203	—	48		—			—			—			48
Stock option based compensation expense	—	—	592		—			—			—			592
Restricted stock expense	—	—	67		—			—			—			67
Dividends (distributions to shareholders)	—	—	—		(684		)	—			—			(684		)
Balance at March 31, 2016	29,460,348	4,723,530	$	188,214	$	16,147		$	47		$	25		$	204,433

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows

For the three months ended March 31, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Three Months Ended March 31,
	2016			2015
Cash flows from operating activities
Net income	$	4,683		$	8,053
Adjustments to reconcile net income to net cash used by operating activities:
Depreciation and amortization	1,065			433
Provision for loan losses	1,433			1,077
Amortization of premium on securities, net of accretion	30			15
Amortization (accretion) of discount on unguaranteed loans, net	146			319
Deferred tax expense	739			226
Originations of loans held for sale	(256,077		)	(223,905		)
Proceeds from sales of loans held for sale	172,638			180,991
Net gains on sale of loans held for sale	(16,425		)	(15,461		)
Net loss on sale of foreclosed assets	—			7
Net increase in servicing assets	(3,147		)	(3,458		)
Gain on sale of investment in non-consolidated affiliate	—			(3,782		)
Net loss on disposal of premises and equipment	—			3
Stock option based compensation expense	592			118
Restricted stock expense	67			8
Equity in loss of non-consolidated affiliates	—			26
Changes in assets and liabilities:
Other assets	516			92
Other liabilities	(146		)	5,265
Net cash used by operating activities	(93,886		)	(49,973		)
Cash flows from investing activities
Purchases of securities available-for-sale	(2,443		)	(1,900		)
Proceeds from sales, maturities, calls, and principal paydowns of securities available-for-sale	890			629
Proceeds from sale/collection of foreclosed assets	52			330
Maturities of certificates of deposit with other banks	1,250			—
Proceeds from sale of investment in non-consolidated affiliate	—			9,896
Net cash acquired in consolidation of equity method investment	—			319
Loan originations and principal collections, net	8,742			26,725
Purchases of premises and equipment, net	(251		)	(3,281		)
Net cash provided by investing activities	8,240			32,718

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

Consolidated Statements of Cash Flows (Continued)

For the three months ended March 31, 2016 and 2015 (unaudited)

(Dollars in thousands)



	Three Months Ended March 31,
	2016			2015
Cash flows from financing activities
Net increase in deposits	210,677			34,003
Proceeds from long term borrowings	—			8,468
Repayment of long term borrowings	(104		)	(107		)
Repayment of short term borrowings	—			(6,100		)
Stock option exercises	48			16
Shareholder dividend distributions	(1,026		)	(1,363		)
Net cash provided by financing activities	209,595			34,917
Net increase in cash and cash equivalents	123,949			17,662
Cash and cash equivalents, beginning	102,607			29,902
Cash and cash equivalents, ending	$	226,556		$	47,564

Supplemental disclosure of cash flow information
Interest paid	$	2,690		$	1,915
Income tax	2,181			1,974

Supplemental disclosures of noncash operating, investing, and financing activities
Unrealized holding gains on available-for-sale securities, net of taxes	$	239		$	124
Transfers from loans to foreclosed real estate and other repossessions	406			—
Transfers of loans accounted for as secured borrowing collateral to other assets	—			4,674
Dividends declared but not paid	—			169
Transfer of loans held for sale to loans held for investment	13,763			2,294
Transfer of loans held for investment to loans held for sale	752			1,370
Contingent consideration in acquisition of controlling interest in equity method of investment	—			170

See Notes to Unaudited Consolidated Financial Statements

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Live Oak Bancshares, Inc.

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. On July 23, 2015 the Company closed on its initial public offering. In 2010, the Bank formed Live Oak Number One, Inc., a wholly-owned subsidiary, to hold properties foreclosed on by the Bank.

During 2011, the Company formed Independence Aviation, LLC, a wholly-owned subsidiary, for the purpose of purchasing and operating aircraft used for business purposes of the Company. The net assets of Independence Aviation, LLC were transferred to the Company and the Bank effective December 31, 2015 resulting in its dissolution.

In addition to the Bank, the Company owns 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 adviser 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 and first quarter of 2016 increased the Company’s ownership to 92.9%. With 7.1% 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 three months ended March 31, 2016 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2016. The consolidated balance sheet as of December 31, 2015 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the Securities Exchange Commission on March 14, 2016 (SEC File No. 001-37497) (the "2015 Annual Report"). 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 2015 Annual Report. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes in the Company's 2015 Annual Report.

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 or where otherwise indicated.

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

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 March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” (“ASU 2016-08”). This guidance amends the previously issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASU 2016-08 clarifies the implementation guidance on principal versus agent considerations in order to determine if revenue will be recognized on a gross or net basis. This guidance is effective for the Company on January 1, 2018 and is not expected to have a material impact on the consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”). ASU 2016-09 simplifies the accounting for share-based payment transactions for items including income tax consequences, classification of awards as equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company on January 1, 2017 and the Company is currently assessing the impact the adoption of this standard will have on the consolidated financial statements.

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.



	Three Months Ended March 31,
	2016		2015
Basic earnings per share:
Net income available to common shareholders	$	4,691	$	8,073
Weighted-average basic shares outstanding	34,176,753		28,620,120
Basic earnings per share	$	0.14	$	0.28
Diluted earnings per share:
Net income available to common shareholders, for diluted earnings per share	$	4,691	$	8,073
Total weighted-average basic shares outstanding	34,176,753		28,620,120
Add effect of dilutive stock options and restricted stock grants	777,839		741,721
Total weighted-average diluted shares outstanding	34,954,592		29,361,841
Diluted earnings per share	$	0.13	$	0.27
Anti-dilutive shares	2,369,813		720,447

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 4. Securities

The carrying amount of securities and their approximate fair values are reflected in the following table:



	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
March 31, 2016
US government agencies	$	22,005	$	129	$	—	$	22,134
Residential mortgage-backed securities	31,627		22		96		31,553
Mutual fund	1,966		21		—		1,987
Total	$	55,598	$	172	$	96	$	55,674

December 31, 2015
US government agencies	$	21,992	$	81	$	5	$	22,068
Residential mortgage-backed securities	30,131		1		374		29,758
Mutual fund	1,951		—		15		1,936
Total	$	54,074	$	82	$	394	$	53,762

During the three months ended March 31, 2016, the Company purchased one mortgage-backed security for $2.4 million for the purpose of complying with the Community Reinvestment Act. During the three months ended March 31, 2016, there was $15 thousand of dividend reinvestment in the 504 Fund mutual fund. There were no calls, sales or maturities of securities during the three months ended March 31, 2016.

There were no calls, sales or maturities of securities during the three months ended March 31, 2015. On March 31, 2015, the Company 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).

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.



	Less Than 12 Months				12 Months or More				Total
March 31, 2016	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Residential mortgage-backed securities	$	16,254	$	73	$	2,978	$	23	$	19,232	$	96
Total	$	16,254	$	73	$	2,978	$	23	$	19,232	$	96
	Less Than 12 Months				12 Months or More				Total
December 31, 2015	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
US government agencies	$	7,990	$	5	$	—	$	—	$	7,990	$	5
Residential mortgage-backed securities	26,015		333		3,019		41		29,034		374
Mutual fund	1,936		15		—		—		1,936		15
Total	$	35,941	$	353	$	3,019	$	41	$	38,960	$	394

At March 31, 2016, there were three mortgage-backed securities in unrealized loss positions for greater than 12 months and six mortgage-backed securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2015 were comprised of three mortgage-backed securities in unrealized loss positions for greater than 12 months and one US government agency security, twelve mortgage-backed securities and the 504 Fund mutual fund investment 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 March 31, 2016 and December 31, 2015 were backed by US government sponsored enterprises (“GSEs”).

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

The following is a summary of investment securities by maturity:



	March 31, 2016
	Available-for-Sale
	Amortized cost		Fair value
US government agencies
Within one year	$	9,212	$	9,229
One to five years	12,793		12,905
Total	22,005		22,134

Residential mortgage-backed securities
Five to ten years	9,095		9,101
After 10 years	22,532		22,452
Total	31,627		31,553

Total	$	53,632	$	53,687

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 March 31, 2016 and December 31, 2015, an investment security with a fair market value of $1.2 million and $1.3 million, respectively, was pledged to secure a line of credit with the Company’s correspondent bank.

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Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Note 5. Loans Held for Investment 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.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

Loans consist of the following:



	March 31, 2016			December 31, 2015
Commercial & Industrial
Agriculture	$	23		$	30
Death Care Management	5,084			4,832
Healthcare	17,365			15,240
Independent Pharmacies	43,185			41,588
Registered Investment Advisors	21,649			18,358
Veterinary Industry	22,385			21,579
Other Industries	7,251			3,230
Total	116,942			104,857
Construction & Development
Agriculture	12,420			11,351
Death Care Management	726			769
Healthcare	8,051			7,231
Independent Pharmacies	279			101
Registered Investment Advisors	286			378
Veterinary Industry	3,646			3,834
Other Industries	1,966			658
Total	27,374			24,322
Owner Occupied Commercial Real Estate
Agriculture	1,929			1,863
Death Care Management	22,318			20,327
Healthcare	44,286			37,684
Independent Pharmacies	7,285			7,298
Registered Investment Advisors	3,035			2,808
Veterinary Industry	61,744			59,999
Other Industries	5,338			4,752
Total	145,935			134,731
Commercial Land
Agriculture	23,081			16,036
Total	23,081			16,036
Total Loans¹	313,332			279,946
Net Deferred Costs	3,330			3,056
Discount on SBA 7(a) Unguaranteed²	(3,029		)	(3,033		)
Loans, Net of Unearned	$	313,633		$	279,969


1	Total loans include $24.6 million and $17.2 million of U.S. government guaranteed loans as of March 31, 2016 and December 31, 2015, respectively.


2	The Company measures the carrying value of the retained portion of loans sold at fair value under ASC Subtopic 825-10. The value of these retained loan balances is discounted based on the estimates derived from comparable unguaranteed loan sales.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

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 select borrowers' 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.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

The following tables summarize the risk grades of each category:



	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total
March 31, 2016
Commercial & Industrial
Agriculture	$	23	$	—	$	—	$	23
Death Care Management	4,971		104		9		5,084
Healthcare	8,187		3,480		5,698		17,365
Independent Pharmacies	38,239		3,328		1,618		43,185
Registered Investment Advisors	20,545		721		383		21,649
Veterinary Industry	17,839		2,066		2,480		22,385
Other Industries	7,251		—		—		7,251
Total	97,055		9,699		10,188		116,942
Construction & Development
Agriculture	11,515		905		—		12,420
Death Care Management	726		—		—		726
Healthcare	8,051		—		—		8,051
Independent Pharmacies	279		—		—		279
Registered Investment Advisors	286		—		—		286
Veterinary Industry	2,453		1,193		—		3,646
Other Industries	1,966		—		—		1,966
Total	25,276		2,098		—		27,374
Owner Occupied Commercial Real Estate
Agriculture	1,929		—		—		1,929
Death Care Management	18,639		2,094		1,585		22,318
Healthcare	40,527		3,032		727		44,286
Independent Pharmacies	6,206		1,079		—		7,285
Registered Investment Advisors	3,035		—		—		3,035
Veterinary Industry	46,570		4,304		10,870		61,744
Other Industries	5,338		—		—		5,338
Total	122,244		10,509		13,182		145,935
Commercial Land
Agriculture	22,362		—		719		23,081
Total	22,362		—		719		23,081
Total¹	$	266,937	$	22,306	$	24,089	$	313,332

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements



	Risk Grades 1 - 4		Risk Grade 5		Risk Grades 6 - 8		Total
December 31, 2015
Commercial & Industrial
Agriculture	$	30	$	—	$	—	$	30
Death Care Management	4,728		104		—		4,832
Healthcare	8,334		2,160		4,746		15,240
Independent Pharmacies	36,704		3,430		1,454		41,588
Registered Investment Advisors	17,508		850		—		18,358
Veterinary Industry	16,800		1,817		2,962		21,579
Other Industries	3,089		141		—		3,230
Total	87,193		8,502		9,162		104,857
Construction & Development
Agriculture	11,194		157		—		11,351
Death Care Management	769		—		—		769
Healthcare	7,231		—		—		7,231
Independent Pharmacies	101		—		—		101
Registered Investment Advisors	378		—		—		378
Veterinary Industry	2,581		1,253		—		3,834
Other Industries	658		—		—		658
Total	22,912		1,410		—		24,322
Owner Occupied Commercial Real Estate
Agriculture	1,863		—		—		1,863
Death Care Management	18,223		425		1,679		20,327
Healthcare	33,529		2,930		1,225		37,684
Independent Pharmacies	6,210		1,088		—		7,298
Registered Investment Advisors	2,808		—		—		2,808
Veterinary Industry	45,453		3,171		11,375		59,999
Other Industries	4,752		—		—		4,752
Total	112,838		7,614		14,279		134,731
Commercial Land
Agriculture	16,036		—		—		16,036
Total	16,036		—		—		16,036
Total¹	$	238,979	$	17,526	$	23,441	$	279,946

Total loans include $24.6 million of U.S. government guaranteed loans as of March 31, 2016, segregated by risk grade as follows: Risk Grades 1 – 4 = $5.9 million, Risk Grade 5 = $3.7 million, Risk Grades 6 – 8 = $15.0 million. As of December 31, 2015, total loans include $17.2 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $0, Risk Grade 5 = $2.6 million, Risk Grades 6 – 8 = $14.6 million.

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements

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.



	Less Than 30 Days Past Due & Not Accruing		30-89 Days Past Due & Accruing		30-89 Days Past Due & Not Accruing		Greater Than 90 Days Past Due		Total Not Accruing & Past Due Loans		Current Loans		Total Loans		Loans 90 Days or More Past Due & Still Accruing
March 31, 2016
Commercial & Industrial
Agriculture	$	—	$	—	$	—	$	—	$	—	$	23	$	23	$	—
Death Care Management	—		—		—		—		—		5,084		5,084		—
Healthcare	78		188		911		3,222		4,399		12,966		17,365		—
Independent Pharmacies	302		589		270		—		1,161		42,024		43,185		—
Registered Investment Advisors	—		—		—		—		—		21,649		21,649		—
Veterinary Industry	201		—		607		885		1,693		20,692		22,385		—
Other Industries	—		—		—		—		—		7,251		7,251		—
Total	581		777		1,788		4,107		7,253		109,689		116,942		—
Construction & Development
Agriculture	—		—		—		—		—		12,420		12,420		—
Death Care Management	—		—		—		—		—		726		726		—
Healthcare	—		—		—		—		—		8,051		8,051		—
Independent Pharmacies	—		—		—		—		—		279		279		—
Registered Investment Advisors	—		—		—		—		—		286		286		—
Veterinary Industry	—		—		—		—		—		3,646		3,646		—
Other Industries	—		—		—		—		—		1,966		1,966		—
Total	—		—		—		—		—		27,374		27,374		—
Owner Occupied Commercial Real Estate
Agriculture	—		—		—		—		—		1,929		1,929		—
Death Care Management	1,423		222		—		—		1,645		20,673		22,318		—
Healthcare	357		258		133		93		841		43,445		44,286		—
Independent Pharmacies	—		—		—		—		—		7,285		7,285		—
Registered Investment Advisors	—		—		—		—		—		3,035		3,035		—
Veterinary Industry	1,363		5,038		908		3,357		10,666		51,078		61,744		—
Other Industries	—		—		—		—		—		5,338		5,338		—
Total	3,143		5,518		1,041		3,450		13,152		132,783		145,935		—
Commercial Land
Agriculture	719		—		—		—		719		22,362		23,081		—
Total	719		—		—		—		719		22,362		23,081		—
Total¹	$	4,443	$	6,295	$	2,829	$	7,557	$	21,124	$	292,208	$	313,332	$	—

Table of Contents

Live Oak Bancshares, Inc.

Notes to Unaudited Consolidated Financial Statements



	Less Than 30 Days Past Due & Not Accruing		30-89 Days Past Due & Accruing		30-89 Days Past Due & Not Accruing		Greater Than 90 Days Past Due		Total Not Accruing & Past Due Loans		Current Loans		Total Loans		Loans 90 Days or More Past Due & Still Accruing
December 31, 2015
Commercial & Industrial
Agriculture	$	—	$	—	$	—	$	—	$	—	$	30	$	30	$	—
Death Care Management	—		—		—		—		—		4,832		4,832		—
Healthcare	—		1,854		30		2,337		4,221		11,019		15,240		—
Independent Pharmacies	314		603		—		—		917		40,671		41,588		—
Registered Investment Advisors	—		—		—		—		—		18,358		18,358		—
Veterinary Industry	208		466		1,131		394		2,199		19,380		21,579		—
Other Industries	—		—		—		—		—		3,230		3,230		—
Total	522		2,923		1,161		2,731		7,337		97,520		104,857		—
Construction & Development
Agriculture	—		—		—		—		—		11,351		11,351		—
Death Care Management	—		—		—		—		—		769		769		—
Healthcare	—		—		—		—		—		7,231		7,231		—
Independent Pharmacies	—		—		—		—		—		101		101		—
Registered Investment Advisors	—		—		—		—		—		378		378		—
Veterinary Industry	—		—		—		—		—		3,834		3,834		—
Other Industries	—		—		—		—		—		658		658		—
Total	—		—		—		—		—		24,322		24,322		—
Owner Occupied Commercial Real Estate
Agriculture	—		—		—		—		—		1,863		1,863		—
Death Care Management	1,456		223		—		—		1,679		18,648		20,327		—
Healthcare	—		240		135		831		1,206		36,478		37,684		—
Independent Pharmacies	—		—		—		—		—		7,298		7,298		—
Registered Investment Advisors	—		—		—		—		—		2,808		2,808		—
Veterinary Industry	311		5,079		2,048		3,172		10,610		49,389		59,999		—
Other Industries	—		—		—		—		—		4,752		4,752		—
Total	1,767		5,542		2,183		4,003		13,495		121,236		134,731		—
Commercial Land
Agriculture	—		—