Armour Residential REIT, Inc. quarterly report, Q2 FY2016

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Armour Residential REIT, Inc. — Q2 2016 Form 10-Q

All dollar amounts are in thousands unless otherwise noted. The quarter and six months ended June 30, 2016 are compared with the corresponding 2015 periods; balance-sheet comparisons are with December 31, 2015.

Business context and reporting period

Armour is a mortgage REIT that invests in residential mortgage-backed securities, primarily Agency securities, using short-term repurchase-agreement financing and derivatives to manage interest-rate exposure. ACM manages the company. In April 2016, Armour acquired JAVELIN Mortgage Investment Corp. for $85.2 million in cash, adding Non-Agency assets; JAVELIN’s results are included from April 6, 2016.

At June 30, 2016, the MBS portfolio comprised 89.1% Agency securities, 10.5% Non-Agency securities and 0.4% interest-only securities. The filing reports 36,703,275 common shares outstanding as of August 1, 2016.

Financial performance and condition

  • Q2 revenue and earnings: Interest income was $65.1 million, down 29.0% year over year; net interest income was $46.9 million, down 39.8%. Net income was $21.2 million, versus $198.0 million in Q2 2015. After preferred dividends, income attributable to common stockholders was $17.3 million, or $0.47 per diluted share, versus $194.1 million, or $4.40 per share.
  • First-half results: Net interest income was $106.2 million, down 34.9%. Net loss was $258.3 million versus net income of $72.5 million in 2015; the loss attributable to common stockholders was $266.1 million, or $7.25 per share, versus income of $64.7 million, or $1.44 per share.
  • Margins and costs: Q2 asset yield was 2.68%, cost of funds 1.33%, net interest margin 1.35%, and repurchase-agreement interest expense rate 0.79%. The six-month net interest rate spread was 1.32%, up from 1.28% in 2015. Management attributed lower net interest income primarily to a smaller average MBS portfolio, despite the modestly higher spread.
  • Other income and unusual items: Q2 other loss was $16.4 million, including $112.5 million of realized derivative losses partly offset by $66.1 million of unrealized derivative gains, $14.6 million of realized Agency-security gains, $10.2 million of Non-Agency gains, and a $6.5 million JAVELIN bargain-purchase gain. First-half derivative losses totaled $381.5 million. These results are affected by fair-value accounting; Armour does not use cash-flow hedge accounting.
  • Cash flow: First-half operating cash flow was negative $245.3 million, compared with positive $110.9 million in 2015. Investing activities provided $4.60 billion, largely reflecting $4.88 billion of Agency-security sale proceeds; financing activities used $4.26 billion. Cash increased by $99.4 million to $389.4 million.
  • Assets, debt and equity: Total assets were $9.54 billion, down from $13.06 billion at year-end; Agency securities fell to $7.74 billion from $12.46 billion. Repurchase borrowings declined to $7.97 billion from $11.57 billion. Stockholders’ equity was $1.14 billion, down from $1.23 billion. Reported leverage was 7.00:1, or 8.95:1 including forward-purchased TBA securities and excluding debt related to forward-settling sales.
  • Liquidity: Management reported liquidity of $507.2 million, consisting of $389.4 million cash and $117.9 million of unpledged Agency securities. The company stated it believed available liquidity and capital resources were sufficient for anticipated short-term needs, including financing obligations and distributions.
  • Dividends: Common dividends declared were $0.71 per share in Q2 and $1.70 per share in the first half, down from $0.96 and $1.92, respectively, in 2015. The monthly common dividend was reduced from $0.33 to $0.27 in April and to $0.22 in May; $0.22 monthly dividends were also declared for August and September payment dates.

Material changes versus the prior comparable period

  • The portfolio contracted substantially: the six-month average MBS portfolio was $10.41 billion, down 24.3% from $14.36 billion in the prior-year comparison. Lower portfolio size drove much of the decline in interest income and net interest income.
  • Derivative performance shifted materially: Q2 2015 included a $134.5 million net derivative gain, versus a $46.4 million net loss in Q2 2016; first-half derivative losses widened to $381.5 million from $73.7 million.
  • The company began investing in Non-Agency securities in Q1 and interest-only securities in Q2, diversifying from its prior all-Agency MBS portfolio. The JAVELIN acquisition contributed $4.9 million of interest income and $3.2 million of net income after acquisition.
  • Agency-security unrealized gains improved accumulated other comprehensive income by $242.5 million in the first half, compared with a $133.6 million loss in the first half of 2015. This was recorded outside net income.

Outlook, risks, contingencies and other matters

  • No specific earnings or dividend guidance was provided. Management said it expected operating cash flow and portfolio adjustments to support anticipated short-term liquidity needs, while noting that longer-term financing could depend on market access and could not be assured.
  • Key exposures include interest-rate and yield-curve movements, mortgage spreads, prepayments, asset/liability repricing mismatch, Non-Agency credit performance, and the availability and cost of repurchase financing. Higher rates or wider spreads can reduce asset values, increase margin calls and pressure net interest income and liquidity.
  • Repurchase agreements had a weighted-average contractual rate of 0.81%, 28-day weighted-average maturity and 6.46% weighted-average haircut at June 30, 2016. Most were short-dated; $5.82 billion repriced or matured within 30 days. Lenders may demand additional collateral or terminate financing under specified circumstances.
  • Non-Agency securities are valued using significant unobservable inputs and classified as Level 3; fair value was $916.6 million. Their value depends on assumptions including defaults, loss severities, delinquencies, prepayments and discount rates.
  • Nine putative class-action suits challenge the JAVELIN tender offer and merger, alleging fiduciary-duty and related claims. Defendants moved to dismiss; plaintiffs opposed the motion in July. The company said it could not estimate the outcome and that an adverse result could involve damages, rescission or unwinding, and substantial defense costs.
  • A Federal Housing Finance Agency rule bars new advances or renewal of Armour’s existing $100 million FHLB advance, which matures in December 2016; the filing said the rule does not directly affect its MRA financing with another FHLB.
  • The company reported effective disclosure controls and procedures and no material change in internal control over financial reporting during the quarter. It stated that risk factors were unchanged from the prior annual report except for the JAVELIN litigation-related risk.

Important facts for investors to verify

  • How the reduced common dividend compares with future REIT taxable income and the company’s distribution requirements; first-half estimated REIT taxable income was $28.9 million versus total dividend payments of $70.3 million.
  • Whether portfolio earnings and net interest spread can recover as asset size, short-term funding costs and prepayment speeds change.
  • The sensitivity of book value, net interest income and collateral needs to market moves; management’s modeled +100 basis-point scenario showed a 1.46% decline in projected net interest income and a 0.43% decline in portfolio value including derivatives.
  • The valuation assumptions and realized performance of the Level 3 Non-Agency portfolio, and the extent to which derivative losses reflect economic hedging versus fair-value timing.
  • Developments in the JAVELIN litigation and any potential financial or operational consequences.
  • Repurchase-agreement rollover, haircut and counterparty concentration risks, and the December 2016 maturity of the $100 million FHLB advance.