Dynex Capital, Inc. — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017. Amounts below are in U.S. dollars; financial statement amounts are generally in millions unless stated otherwise.
Business context and reporting period
Dynex is an internally managed mortgage REIT investing on a leveraged basis in Agency and non-Agency residential and commercial mortgage-backed securities, including CMBS interest-only securities. It uses repurchase agreements for most of its financing and interest-rate swaps to manage some interest-rate exposure. Its stated objective is long-term risk-adjusted returns, with a focus on capital preservation and quarterly dividends.
Key financial metrics
| Metric | Q1 2017 / March 31, 2017 | Comparable period or prior date |
|---|---|---|
| Interest income | $22.4 million | $25.1 million in Q1 2016 |
| Interest expense / net interest income | $7.5 million / $14.9 million | $6.3 million / $18.8 million in Q1 2016 |
| Net income (loss) | $9.1 million; $6.6 million to common shareholders | $(37.4) million; $(39.7) million to common shareholders in Q1 2016 |
| Net income (loss) per common share | $0.13 | $(0.81) in Q1 2016 |
| Other comprehensive income / comprehensive income to common shareholders | $20.0 million / $26.6 million | $41.7 million / $2.0 million in Q1 2016 |
| Core net operating income, non-GAAP | $7.4 million; $0.15 per common share | $10.0 million; $0.20 per share in Q4 2016 |
| Total assets / shareholders’ equity | $3,339.9 million / $492.5 million | $3,397.7 million / $467.2 million at December 31, 2016 |
| Repurchase agreements | $2,825.9 million; weighted-average rate 1.15% | $2,899.0 million; 1.03% at December 31, 2016 |
| Cash and cash equivalents | $65.9 million; restricted cash was $34.8 million | $74.1 million and $24.8 million, respectively, at December 31, 2016 |
| Available liquid assets | $182.7 million | $138.1 million at December 31, 2016 |
| Book value per common share | $7.52 | Up $0.34 from December 31, 2016 |
Net cash provided by operating activities was $47.1 million, versus $53.6 million in Q1 2016. Investing activities provided $33.7 million, versus $170.6 million; financing activities used $89.0 million, versus $175.2 million. Cash and cash equivalents decreased $8.2 million during the quarter. These cash-flow totals include substantial investment and financing turnover and should not be read as operating earnings.
Mortgage-backed securities were $3,186.7 million at fair value, down from $3,212.1 million at year-end. Total liabilities were $2,847.4 million. Total liabilities were 5.8 times shareholders’ equity, compared with 6.3 times at year-end; company policy limits this ratio to 8 times equity.
Material changes versus comparable periods
- Q1 net income improved substantially from the prior-year loss, when derivative fair-value losses were $48.3 million. Q1 2017 derivative gains were $0.2 million.
- Net interest income fell 20.7% year over year. Management attributed the decline primarily to a smaller investment portfolio, higher borrowing costs, lower CMBS prepayment-penalty compensation, and greater RMBS premium amortization.
- GAAP cost of funds rose to 1.06% from 0.81% in Q1 2016. Adjusted cost of funds, a non-GAAP measure that includes swap costs, increased to 1.16% from 1.02%.
- Q1 comprehensive income benefited from $20.0 million of other comprehensive income, chiefly from MBS fair-value gains associated with tighter credit spreads. Book value per common share rose, while management said dividends declared exceeded core net operating income and capital-stock activity also affected book value.
- The portfolio continued shifting toward CMBS as capital returned from hybrid ARMs was reinvested mainly in Agency CMBS. The company sold lower-yielding Agency RMBS and reported a $1.7 million realized loss on investment sales.
- Repurchase-agreement borrowings declined from year-end, but their weighted-average rate increased. The average remaining repo term was 18 days, underscoring reliance on short-term funding.
Outlook, risks, contingencies and unusual items
- Outlook: No numerical earnings or dividend guidance is provided. Management expected multiple Federal Funds rate increases during 2017 to raise funding costs, and cited elevated near-term interest-rate and spread volatility and regulatory uncertainty. It said it was maintaining conservative leverage and actively managing hedges, while seeking investment and funding diversification opportunities.
- Rate and spread exposure: Modelled sensitivities for an instantaneous parallel rate increase of 100 basis points show a 0.34% decrease in portfolio market value and a 16.99% decrease in adjusted net interest income; a 50-basis-point increase shows decreases of 0.14% and 8.03%, respectively. A 50-basis-point credit-spread widening is estimated to reduce investment market value by 2.26%. These are model estimates, assume specified conditions, and do not include all possible market changes.
- Funding and liquidity: Most repo financing is short-term, uncommitted, and renewable at lender discretion; lenders may require additional collateral after asset-value declines. Repo maturities, margin calls, counterparty concentration, reduced market liquidity, or higher financing costs could force asset sales. The company reported compliance with financing covenants at quarter-end.
- Portfolio risks: Key risks include interest rates, prepayments and reinvestment, credit performance, asset market values, and liquidity. CMBS IO returns can be affected by defaults or early loan repayments. Agency MBS retain interest-rate and prepayment risks despite principal guarantees; non-Agency securities carry credit risk.
- Legal contingency: After quarter-end, a suit filed April 26, 2017 sought to enforce a $46.5 million judgment entered against former affiliate DCI against Dynex as well, alleging fraudulent transfers and related claims. Dynex called the suit baseless and intends to defend it, but stated that an adverse resolution could materially affect its consolidated financial statements in a given quarter. The outcome cannot be predicted.
- Dividends and capital: The company declared a $0.18-per-share common dividend for Q1, payable April 28, 2017. It issued 325,201 Series B preferred shares through its ATM program for $7.5 million net proceeds. Management estimated approximately 88% of Q1 common dividends would be treated as return of capital, principally due to tax hedge-loss deductions. The company also amended its common-stock ATM agreement, authorizing sales of up to 7,416,520 shares; no shares were issued under that agreement in Q1.
- Other disclosures: Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It identified no significant subsequent events other than matters disclosed in the filing. The company was evaluating the effect of a new accounting standard for certain callable debt securities.
Most important facts for investors to verify
- Whether rising short-term rates and the short maturity of repo funding further pressure net interest income, liquidity, or collateral requirements.
- Whether the $182.7 million of reported available liquid assets remains adequate under adverse rate, spread, and financing-market scenarios.
- Whether portfolio fair-value gains, credit spreads, prepayment assumptions, and model inputs support reported book value and future premium amortization.
- How core net operating income compares with the common dividend over subsequent quarters; core net operating income is a company-defined non-GAAP measure, not GAAP earnings.
- The progress and potential financial exposure from the post-quarter legal suit concerning the $46.5 million judgment against DCI.
- The effect of additional preferred or common equity issuance, including ATM activity, on common shareholders’ book value and per-share returns.