Armour Residential REIT, Inc. — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. Financial statements are unaudited. Amounts are U.S. dollars unless noted.
Business context
Armour is an externally managed mortgage REIT investing primarily in residential mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. It finances most holdings with short-term repurchase agreements and uses derivatives to manage interest-rate exposure. At June 30, all reported Agency Securities were classified as available for sale.
Financial performance and position
- Q2 results: Net interest income was $75.1 million, versus $26.8 million in Q2 2011. Net loss was $13.6 million, or $0.08 per basic and diluted share, compared with a $7.3 million loss, or $0.14 per share. The quarter included $82.8 million of total derivative losses, including $70.4 million unrealized.
- First-half results: Net interest income was $130.9 million, versus $38.9 million in 2011. Net income was $51.6 million, or $0.33 basic and $0.32 diluted per share, compared with $1.3 million, or $0.03 per share. Net derivative losses were $74.9 million.
- Interest margin: Q2 asset yield was 2.97%, cost of funds 0.82%, and net interest margin 2.15%, down from 3.35%, 0.99%, and 2.36%, respectively, in Q2 2011. The Q2 portfolio repayment rate was 9.1%, versus 9.3% a year earlier.
- Assets and equity: Total assets were $13.91 billion, up from $6.21 billion at December 31, 2011. Agency Securities at fair value were $13.33 billion, versus $5.39 billion. Stockholders’ equity was $1.36 billion, versus $626.6 million. First-half comprehensive income of $170.5 million included $118.9 million of other comprehensive income, primarily unrealized securities gains.
- Debt and liquidity: Repurchase-agreement borrowings were $12.11 billion, versus $5.34 billion at year-end; weighted-average funding cost was 0.40%, and weighted-average maturity was 32 days. Leverage was 8.92:1, compared with 8.52:1. Cash was $326.7 million and restricted cash $193.1 million. The repo haircut averaged 4.8%.
- Cash flows, first half: Operating activities provided $87.9 million; investing activities used $7.35 billion; financing activities provided $7.34 billion. Cash increased $74.4 million to $326.7 million. Financing included $627.8 million net common-equity proceeds and $33.8 million net preferred-equity proceeds.
- Distributions: Common dividends totaled $0.62 per share in the first half, down from $0.70 in the prior-year period. Q2 common dividends were $0.30 per share, versus $0.36. The Series A preferred stock carries an 8.25% annual dividend rate.
Changes, outlook and notable items
- Growth in net interest income and assets primarily reflected substantial equity raises and investment of the proceeds. Common shares issued and outstanding increased to 188.2 million at June 30 from 95.4 million at year-end. Management cautioned that results and per-share comparisons may be affected by ongoing capital raising and may not represent a full run-rate.
- The portfolio’s fixed-rate share rose to 78.6% from 47.8% at year-end. Agency Securities were held at a net premium to par: amortized cost was 104.77% of principal, versus 104.23% at year-end. Higher prepayments can accelerate premium amortization and reduce yield.
- Management reported that it believed available equity, operating cash flow and borrowing capacity would cover anticipated short-term needs, including investment activity, debt repayments and dividends. It gave no earnings or dividend guidance.
- Interest-rate hedges expanded: swap notional increased to $6.0 billion from $2.8 billion; the company also held $0.8 billion of swaptions. Derivative fair-value changes flow through earnings because the company does not apply cash-flow hedge accounting, potentially making reported earnings volatile.
- A repo counterparty bankruptcy contributed $1.1 million of a $1.3 million Q2 realized securities-sale loss; the company also recorded $1.0 million of other income related to that counterparty. First-half securities sales generated a $5.0 million realized gain.
- After quarter-end, Armour completed a common-stock offering of 46 million shares, with net proceeds of $324.6 million. It also filed an automatic shelf registration and entered into additional equity distribution arrangements. A $0.10 common dividend was paid July 30.
- Key risks include interest-rate and prepayment changes, short-term funding and margin calls, reliance on repo lenders, potential forced sales, GSE and housing-finance policy changes, and uncertainty about continued reliance on the Investment Company Act exemption. Management said disclosure controls were effective and reported no material change in internal control over financial reporting. The company reported no pending litigation and no material changes to previously disclosed risk factors.
Important facts for investors to verify
- Whether net interest margin and earnings can withstand changing short-term rates, prepayments and premium amortization.
- Repo renewal, counterparty concentration, collateral haircuts, margin-call capacity and the implications of 8.92:1 leverage.
- How hedge performance and non-cash derivative marks affect reported earnings, book value and distributions.
- Effects of substantial share issuance, the post-quarter offering and management fees tied to gross equity raised on per-share results.
- Whether REIT distribution requirements and available taxable income support future dividends; GAAP earnings and REIT taxable income differ materially.
- Potential consequences of GSE reform or changes to the company’s investment-company exemption.