ANNALY CAPITAL MANAGEMENT INC quarterly report, Q3 FY2012

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Business context and reporting period

Annaly Capital Management, Inc. is a REIT that invests primarily in agency mortgage-backed securities and finances them largely with short-term repurchase agreements. Its results depend chiefly on the spread between investment yields and funding costs, interest-rate and prepayment movements, leverage, and hedge performance. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2012; comparisons are with the same 2011 periods unless noted.

Financial performance and position

  • Quarterly results: Interest income was $761.3 million, down from $930.8 million; GAAP net interest income was $579.4 million, down from $809.4 million. Net income was $224.8 million, or $0.22 per diluted share, versus a $921.8 million net loss, or $0.98 loss per share. The 2012 result includes an $87.3 million debt-extinguishment loss.
  • Nine-month results: Interest income was $2.50 billion versus $2.73 billion; GAAP net interest income was $2.02 billion versus $2.38 billion. Net income was $1.04 billion, or $1.04 per diluted share, versus a $101.1 million net loss, or $0.14 loss per share.
  • Spread and yields: Q3 economic net interest income, which includes net interest-rate swap payments, was $355.1 million versus $577.5 million. The economic net interest spread fell to 1.02% from 2.08%, as asset yield dropped 117 basis points to 2.54%; average funding cost eased 11 basis points to 1.52%. The nine-month spread was 1.41% versus 2.23%.
  • Other income and expenses: Q3 realized investment-sale gains were $142.2 million, while realized and unrealized swap losses were $328.5 million combined. Total expenses were $63.0 million. Nine-month investment-sale gains were $317.3 million; combined swap losses were $1.04 billion.
  • Dividends: Common dividends declared were $0.50 per share for Q3 and $1.60 for the first nine months, versus $0.60 and $1.87 in 2011. The Q3 dividend was payable October 29, 2012.
  • Balance sheet at September 30: Total assets were $141.6 billion, including $129.6 billion of agency MBS; stockholders’ equity was $17.1 billion. Cash and cash equivalents were $2.26 billion. Repurchase agreements totaled $101.0 billion, up from $84.1 billion at December 2011; convertible notes were carried at $999.7 million. Debt-to-equity was 6.0:1, compared with 5.4:1 at year-end.
  • Funding and liquidity: Repo borrowing rates averaged 0.61% before swap effects; the reported weighted-average cost for repos after swaps was 1.52%. Repo agreements had a 213-day weighted-average remaining maturity. Pledged collateral was $108.9 billion, with an estimated $11.3 billion excess collateral cushion and approximately 5% average repo haircut. The company reported no repo margin calls it could not meet.
  • Cash flows: Nine-month operating, investing, and financing cash flows were $7.29 billion, negative $15.44 billion, and positive $9.42 billion, respectively; cash increased $1.27 billion to $2.26 billion. Operating cash flow includes substantial matched-book repo and securities-lending activity, so it should not be read as ordinary operating cash generation.

Material changes versus comparable periods

  • Despite higher average interest-earning assets, lower asset yields and faster prepayments reduced interest income and economic net interest income. Q3 average asset yield was 2.54%, compared with 3.71% a year earlier; average CPR increased to 20% from 18%.
  • The reported swing from Q3 2011 loss to Q3 2012 profit was principally due to $1.4 billion less in unrealized swap losses, not an improvement in the underlying spread. Management also attributed the nine-month year-over-year earnings improvement chiefly to lower unrealized swap losses.
  • Agency MBS fair value rose to $129.6 billion from $104.3 billion at year-end 2011. Net unrealized gains in accumulated other comprehensive income were $4.07 billion, up from $3.01 billion.
  • The company issued $750 million of 5% convertible notes and new Series C and Series D preferred shares in 2012, and converted all remaining Series B preferred shares into common stock. During Q3 it repurchased about $280.7 million principal of 4% convertible notes for $357.2 million, recording the $87.3 million loss noted above.

Outlook, commentary, and risks

The filing gives no formal earnings or dividend guidance. Management said the spread had declined each quarter over the prior year and could continue to narrow amid low rates, declining coupons, higher acquisition prices, prepayments, or higher funding costs. At September 30, the portfolio’s estimated weighted-average yield was 2.79%, and estimated funding cost was 1.55%, for an estimated spread of 1.24%.

Key risks include changes in interest rates and the yield curve, mortgage prepayments and premium amortization, falling collateral values and margin calls, availability and terms of repo financing, derivative-counterparty performance, and market or regulatory developments. Interest-rate swaps had $46.7 billion notional and a $2.93 billion net liability; certain agreements allow counterparties termination rights under specified events. Exposure to European financial counterparties was reported at $1.76 billion, or 1.24% of assets. The company noted uncertainty around SEC review of its Investment Company Act exemption and stated that it believed it remained compliant with REIT and exemption requirements. Management said ordinary-course legal matters were not expected to materially affect the financial statements; risk factors were reported as unchanged from the latest 10-K.

Subsequent to quarter-end, Annaly repurchased a further $166.4 million principal of 4% convertible notes for $206.9 million. Management’s interest-rate sensitivity model estimated economic net interest income would rise 0.46% under a 25-basis-point rate increase and fall 0.54% under a 50-basis-point increase; modeled values are estimates and actual results may differ.

Important facts for investors to verify

  1. Whether the weaker spread, lower asset yields, and higher prepayment speeds persisted after Q3.
  2. How much reported earnings and book value movements reflect swap mark-to-market changes versus recurring net interest income; review the company’s economic, non-GAAP measures alongside GAAP results.
  3. Repo leverage, maturity profile, collateral haircuts and cushion, and the ability to meet margin calls if asset values fall or funding tightens.
  4. Potential dilution, refinancing cost, and cash consequences of convertible-note repurchases and conversions, and the sustainability of common and preferred dividends.
  5. Counterparty, REIT qualification, and Investment Company Act exemption developments, including any changes in SEC interpretation.