Armour Residential REIT, Inc. quarterly report, Q2 FY2015

Armour Residential REIT, Inc. — Q2 2015 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2015. The unaudited financial statements are consolidated and amounts below are in thousands of dollars, except per-share data, ratios, and where noted. Armour is an externally managed mortgage REIT whose securities portfolio consisted entirely of agency mortgage-backed securities.

Financial results and position

Metric	Q2 2015	Q2 2014	Six months 2015	Six months 2014
Net interest income	$77,786	$94,650	$163,145	$202,985
Total other income (loss)	$129,478	$(155,385)	$(72,218)	$(273,610)
Net income (loss)	$198,018	$(70,190)	$72,549	$(89,968)
Net income (loss) available to common	$194,113	$(74,095)	$64,739	$(97,780)
Basic EPS, before announced reverse split	$0.55	$(0.21)	$0.18	$(0.27)

Q2 net income included a $194,507 unrealized gain on derivatives, while available-for-sale agency securities recorded a $221,802 net unrealized loss in other comprehensive income. Q2 comprehensive loss was $18,733.
Net interest income fell 17.8% in Q2 and 19.6% for the first half year over year. Management attributed the decline to a smaller average portfolio and narrower spreads. The six-month average portfolio was $14.357 billion versus $15.685 billion; the six-month net interest rate spread was 1.28% versus 1.64%.
Q2 net interest margin was 1.36%, compared with 1.46% in Q2 2014. Q2 2015 asset yield was 2.60%; cost of funds, including applicable swaps, was 1.24%.
At June 30, total assets were $15.124 billion, including agency securities of $13.796 billion. Repurchase-agreement borrowings were $13.423 billion; total liabilities were $13.537 billion and stockholders’ equity was $1.587 billion. Agency securities’ weighted average coupon was 3.45%.
Cash was $363.212 million and reported liquidity was $884.999 million, comprising cash and $521.787 million of unpledged agency securities. Leverage was 8.46:1 excluding TBA securities and 9.05:1 including them. The weighted average repurchase-agreement rate was 0.40%, weighted average maturity 52 days, and haircut 4.81%.
For the six months, operating cash flow was $110.936 million, investing cash flow was $318.822 million, and financing cash flow was $(561.107) million. Cash declined by $131.349 million to $363.212 million. Cash dividends paid included $84.753 million on common stock and $7.811 million on preferred stock.

Material changes and notable items

Agency securities declined in fair value from $15.298 billion at year-end 2014 to $13.796 billion at June 30, 2015. Gross unrealized losses were $98.992 million, offset by $49.782 million of unrealized gains; no other-than-temporary impairment was recognized.
Accumulated other comprehensive income of $84.354 million at year-end became an accumulated loss of $49.210 million. Total stockholders’ equity declined from $1.749 billion to $1.587 billion.
Management reported that generally rising rates in 2015, versus falling rates in 2014, drove the contrasting derivative and securities valuation results. Derivative fair-value changes are recorded in earnings rather than hedge accounting; therefore GAAP income may be volatile and differ from underlying spread performance.
The company repurchased 3.075 million common shares for $9.497 million during the first half. A one-for-eight reverse split was scheduled to take effect after July 31, 2015; reported Q2 EPS is pre-split, with the filing showing pro forma Q2 EPS of $4.40 post-split. The common dividend was $0.04 monthly before the split; subsequent declared dividends were stated as $0.33 per post-split share.
Estimated REIT taxable income for the first half was $71.962 million, versus total dividends paid of $92.564 million. The filing says dividend and REIT distribution requirements are determined annually.

Outlook, risks, and contingencies

No numerical earnings or portfolio guidance was provided. Management stated it believed available liquidity, operating cash flow, and borrowing arrangements would meet anticipated short-term needs, including investments, financing obligations, expenses, and distributions.
Key risks include short-term repo funding against longer-duration assets, interest-rate and yield-curve movements, prepayment speeds, premium amortization, collateral haircuts and margin calls, and the availability and cost of repo financing. The company warns that insufficient liquidity could force asset sales under unfavorable conditions.
At June 30, eight repo counterparties each represented 5%–10% of borrowings and together accounted for approximately 53.42% of repo borrowings. A decline in collateral values or tighter lender requirements could increase margin needs or restrict funding.
Interest-rate sensitivity estimates showed that an immediate 100-basis-point increase was projected to reduce net interest income 5.85% and portfolio value including derivatives 0.60%; a 100-basis-point decrease was projected to increase net interest income 6.46% and portfolio value 0.26%. These are model-based estimates, not forecasts, and the filing cautions actual outcomes may differ materially.
A newly disclosed risk concerns the insurance subsidiary’s Federal Home Loan Bank of Des Moines membership. A proposed rule could make the subsidiary ineligible; termination could require advances to be unwound promptly and could result in losses. No pending or threatened litigation was reported, and the company reported no material changes to other previously disclosed risk factors.
The external manager’s fee is based on gross equity raised rather than asset performance; management noted fees may not decline when earnings decline. The manager agreement also involves related-party relationships and potential conflicts of interest.

Important facts for investors to verify

Whether net interest income and spread stabilize, and how rate changes and prepayments affect portfolio yield and premium amortization.
Liquidity, repo counterparty concentration, collateral haircuts, margin-call exposure, and leverage—especially including TBA positions.
The split-adjusted share count, per-share dividend rate, and dividend coverage by annual REIT taxable income.
The effect of derivative valuation volatility on GAAP earnings and equity, relative to underlying portfolio economics.
The final outcome of the proposed FHLB membership rule and any effect on the insurance subsidiary or outstanding advances.