Invesco Mortgage Capital Inc. — Q2 2018 Form 10-Q
Business context and reporting period
Quarter ended June 30, 2018; unaudited. Invesco Mortgage Capital is an externally managed mortgage REIT investing primarily in residential and commercial mortgage-backed securities, credit-risk-transfer securities and mortgage loans. Its stated objective is to provide returns primarily through dividends and secondarily through capital appreciation.
Financial performance and position
- Q2 revenue and earnings: Interest income was $151.6 million, up from $127.0 million a year earlier. Net interest income was $73.7 million, down from $82.9 million. Net income attributable to common stockholders was $80.0 million, or $0.72 per diluted share, versus $46.8 million, or $0.41 diluted, in Q2 2017.
- First half: Interest income was $304.8 million versus $251.7 million; net interest income was $158.8 million versus $169.2 million. Common-stockholder income was $121.5 million, or $1.08 diluted per share, compared with $134.0 million, or $1.15. Core earnings, a non-GAAP measure, were $96.5 million, or $0.86 per share, versus $91.0 million, or $0.82.
- Margins and costs: GAAP net interest margin was 1.38% for Q2 and 1.51% for the first half, down from 1.91% and 1.94%, respectively, in 2017. Average cost of funds rose to 2.04% in Q2 from 1.26%; management attributed margin pressure to rising funding rates outpacing asset-yield increases.
- Portfolio and equity: Mortgage-backed and credit-risk-transfer securities had fair value of $17.58 billion at June 30, down from $18.19 billion at year-end. Total equity was $2.51 billion. Book value per diluted common share was $17.06, down 7.0% from $18.35 at year-end, mainly because higher interest rates reduced MBS valuations more than hedge valuations increased.
- Debt and liquidity: Repurchase agreements were $13.70 billion and secured loans were $1.65 billion; total borrowings were $15.35 billion, compared with $15.87 billion at year-end. Exchangeable notes were fully retired at maturity in March 2018. Reported debt-to-equity was 6.1x and repurchase-agreement debt-to-equity was 6.5x. Cash and cash equivalents were $70.3 million, with no restricted cash at quarter-end.
- Cash flows and distributions: First-half operating cash flow was $147.8 million; investing activities provided $472.6 million and financing activities used $639.2 million. Cash, cash equivalents and restricted cash decreased $18.7 million. Common dividends declared were $0.42 per share for Q2, versus $0.40 a year earlier; first-half declarations totaled $0.84 per share.
Material changes versus comparable periods
- Q2 net income improved year over year despite lower net interest income, reflecting a $67.2 million derivative gain versus a $53.5 million loss in Q2 2017. Investment results were a $36.4 million loss versus an $11.2 million gain, and credit-derivative income fell to $0.7 million from $21.4 million.
- For the first half, reported common earnings declined despite a $200.5 million derivative gain, as investment losses were $196.7 million versus a $9.3 million gain in 2017. Net interest income also declined $10.4 million. Core earnings per share increased to $0.86 from $0.82, underscoring the effect of market-value movements on GAAP results.
- Average earning assets expanded, and average earning-asset yield rose to 3.42% in Q2 from 3.17%. Average borrowings and funding costs also increased. Management linked portfolio growth partly to investment of proceeds from the August 2017 Series C preferred-stock offering.
Outlook, risks and unusual items
- Management expected moderate U.S. growth and inflation at or below the Federal Reserve’s 2% objective, while anticipating continued monetary tightening and a relatively volatile rate environment. It cited trade tensions, high asset valuations and potential interest-rate volatility as investor concerns. No earnings or dividend guidance was provided.
- The company said it believed available operating cash flow and borrowing capacity would meet anticipated short-term needs, but noted that long-term liquidity depends on obtaining additional financing. Most repurchase agreements mature within one year, creating refinancing and margin-call exposure. Management cautioned that sufficient liquidity to meet margin calls cannot be assured.
- Illustrative interest-rate sensitivity showed a 100-basis-point increase could reduce projected net interest income 24.29% and portfolio value 1.54%; results are model-based estimates, not forecasts. Management noted that a modeled rate floor limits the benefit of falling rates.
- Key exposures include rate and spread movements, prepayment and extension risk, credit losses, collateral values, financing availability, counterparty performance and hedging effectiveness. The company reported compliance with repurchase-agreement covenants and derivative financial provisions at June 30.
- Unrealized losses on securities were $421.9 million at quarter-end, up from $165.3 million at year-end; management attributed losses principally to non-credit market factors and said it did not consider the identified losses other-than-temporary, subject to quarterly review. No allowance for commercial-loan losses was recorded.
- Undrawn commitments were $7.5 million for unconsolidated ventures and $2.7 million for commercial loans. The company reported no material change in previously disclosed risk factors, no legal proceedings at quarter-end, and effective disclosure controls.
Most important facts for investors to verify
- Whether rising funding costs continue to compress net interest margin and whether core earnings support the common dividend.
- How much of reported earnings and book-value movement reflects fair-value changes in securities versus realized operating performance.
- Repurchase-agreement rollover, lender haircuts, collateral values and liquidity available for potential margin calls.
- Interest-rate and spread sensitivity, including hedge effectiveness, prepayment assumptions and the modeled rate floor.
- Credit performance and geographic concentration in non-Agency holdings, and the status of unfunded commitments.