Orchid Island Capital, Inc. — 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018; the filing also reports fourth-quarter results. Orchid is an externally managed mortgage REIT investing primarily in agency residential mortgage-backed securities (RMBS), financed mainly through short-term repurchase agreements. Agency guarantees cover principal and interest, not market value.
Financial results and position
| Metric | 2018 | 2017 |
|---|---|---|
| Interest income | $154.6 million | $146.0 million |
| Interest expense | $70.4 million | $41.7 million |
| Net interest income | $84.2 million | $104.3 million |
| GAAP net income (loss) | $(44.4) million; $(0.85) per share | $2.0 million; $0.05 per share |
| Dividends declared per share | $1.07 | $1.68 |
| Average asset yield / average funding cost | 4.32% / 2.06% | 4.08% / 1.26% |
| Average economic funding cost / economic spread | 2.14% / 2.18% | 1.70% / 2.38% |
- Net portfolio losses were $32.4 million, reflecting $141.0 million of realized and unrealized RMBS losses, partly offset by $24.3 million of derivative gains. RMBS fair-value changes flow through earnings. The company’s non-GAAP net earnings excluding realized and unrealized gains and losses were $72.3 million, or $1.38 per share; this measure is not a substitute for GAAP results.
- Fourth-quarter 2018: net interest income was $17.3 million, portfolio losses were $40.7 million, and net loss was $26.4 million, or $0.52 per share. Net interest income declined sequentially through 2018 as funding costs rose.
- At year-end, total assets were $3.40 billion, including $3.01 billion of RMBS; borrowings were $3.03 billion, total liabilities $3.06 billion, and stockholders’ equity $336.1 million. Book value was $6.84 per share, down from $8.71 a year earlier. Ending leverage was 9.1:1 versus 7.7:1.
- Cash and cash equivalents were $108.3 million, restricted cash $18.0 million, and unpledged securities $22.9 million. Operating cash flow was $94.0 million; cash, cash equivalents and restricted cash fell by $120.4 million during the year.
- Repurchase agreements had a 2.65% weighted-average borrowing rate and 31-day weighted-average remaining maturity at year-end. The portfolio’s average prepayment speed in Q4 was 7.2%, versus 9.1% in Q4 2017.
Material changes versus 2017
- Net interest income fell $20.1 million despite higher interest income: the 80-basis-point rise in average funding cost and slightly higher average borrowings increased interest expense by $28.7 million. The GAAP net interest spread narrowed from 2.82% to 2.26%.
- GAAP results shifted from $2.0 million net income to a $44.4 million net loss, principally because RMBS losses were larger. The 2018 loss included $110.7 million of unrealized RMBS losses and $30.3 million of realized RMBS sale losses.
- RMBS fair value fell from $3.74 billion to $3.01 billion. The portfolio mix shifted: fixed-rate CMOs were $741.9 million at year-end 2018, while hybrid ARM holdings reported at year-end 2017 were no longer held.
- Repurchases reduced outstanding common shares: 3.98 million shares were repurchased in 2018 for approximately $26.4 million at a weighted-average $6.64 per share. No public-offering shares were issued in 2018.
Outlook, commentary and risks
- Management provided no quantified earnings or dividend guidance. It described a sharp change in the market outlook during Q4: economic and market concerns increased, Treasury yields declined late in the quarter, and the Federal Reserve shifted toward a data-dependent stance. Management expected mortgage prepayment characteristics to be an important driver of relative RMBS performance, citing lower mortgage rates and a subsequent rise in refinancing activity.
- The company continued monthly distributions; it declared $0.08 per share in January 2019, paid in February, and another $0.08 in February, payable in March. The board sets distributions at its discretion, and the filing gives no assurance they will continue at the same level. The 2018 tax characterization included a return-of-capital portion; the filing states $0.40 per share of 2018 distributions was return of capital for tax purposes.
- Principal risks include rising or volatile interest rates, yield-curve flattening or inversion, mortgage spread widening, prepayment and extension risk, short-term repo refinancing and margin calls, leverage, hedging and counterparty risk, and valuation/model uncertainty. Agency guarantees do not protect against market-price declines.
- Management discussed uncertainty around Fed balance-sheet policy, proposed housing-finance reform and the planned transition from LIBOR to SOFR. It also noted the planned June 2019 start of the Fannie Mae/Freddie Mac Uniform Mortgage-Backed Security program and potential liquidity or market effects.
- Interest-rate sensitivity estimates are model-based and assume a static portfolio and no change in mortgage spreads. For year-end 2018, the filing estimated that a 100-basis-point rate rise would increase portfolio value by 0.89% and book value by 8.00%; management cautions actual results could differ materially.
- The company reported no material pending legal proceedings, no material capital-expenditure commitments and no off-balance-sheet arrangements. The auditor issued an unqualified opinion, and management and the auditor reported effective internal control over financial reporting.
Important facts for investors to verify
- Whether recurring net interest income and distributions can withstand higher funding costs and narrower spreads; compare GAAP results with the company’s non-GAAP measures.
- Book value, portfolio fair values, leverage and available liquidity, including repo maturities, collateral haircuts and potential margin requirements.
- How RMBS price changes, mortgage spreads and prepayments affect realized performance; assess the assumptions behind management’s sensitivity and valuation models.
- The sustainability and tax composition of distributions, particularly given 2018 GAAP losses and the reported return-of-capital component.
- Progress and actual portfolio or funding effects from LIBOR transition, Fed policy and housing-finance or UMBS developments.
- Potential conflicts and costs in the external-management arrangement, including management fees and the termination fee for ending the agreement without cause.