Annaly Capital Management, Inc. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Annaly is an externally managed mortgage REIT investing primarily in Agency mortgage-backed securities (MBS), with commercial real estate, middle-market lending, advisory and broker-dealer businesses. Unless otherwise stated, amounts are U.S. dollars.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net interest income | $517.6 million | $551.7 million | $1.606 billion | $1.660 billion |
| Economic net interest income, including swap interest (non-GAAP) | $348.5 million | $323.8 million | $955.9 million | $993.9 million |
| Net interest margin (economic, including swaps) | 1.61% | 1.34% | 1.51% | 1.19% |
| Net income (loss) | $354.9 million | $192.5 million | $(184.0) million | $2.701 billion |
| Net income (loss) per basic common share | $0.36 | $0.18 | $(0.25) | $2.79 |
| Core earnings per basic common share (non-GAAP) | $0.31 | $0.28 | $0.84 | $0.86 |
Q3 core earnings were $308.6 million, up from $282.3 million a year earlier, as economic net interest income and margin improved. For the nine-month period, core earnings were $848.8 million versus $872.9 million. Management cautions that core earnings is a non-GAAP measure and is not a substitute for GAAP results.
- Q3 interest income was $644.6 million and interest expense was $127.1 million. Average earning assets were $86.3 billion, yielding 2.99%; average interest-bearing liabilities were $72.4 billion, at an economic cost of 1.64% including swaps.
- Total assets were $87.4 billion at quarter-end, including an $81.5 billion Agency MBS portfolio. Asset portfolio value was reported as $84.6 billion on the basis used in management’s portfolio discussion.
- Cash and cash equivalents were $1.179 billion, including $1.012 billion pledged as collateral. Unencumbered financial assets were $9.656 billion; approximately $74.3 billion of assets were pledged. Management reported liquid assets equal to 94.58% of total assets, including assets already pledged.
- Stockholders’ equity was $13.111 billion; common book value was $12.87 per share, up from $12.13 at December 31, 2013. Capital ratio was 15.0%, versus 15.1%; leverage was 5.4:1, versus 5.0:1.
- Repurchase agreements totaled $69.611 billion, at a 0.58% weighted-average contractual rate and 159-day weighted-average remaining maturity. Convertible senior notes were recorded at $836.6 million; $857.5 million principal was included in obligations due within one year. Consolidated securitized debt was $260.7 million.
- For the nine months, operating cash flow was $4.799 billion, investing cash flow was $(6.429) billion and financing cash flow was $2.256 billion; cash increased $626.2 million. Operating cash flows include substantial repo and broker-dealer transaction turnover and should not be read as a simple measure of recurring earnings.
Material changes versus comparable periods
- Q3 net income rose year over year, mainly as swap-related unrealized gains improved by $92.3 million and realized swap losses declined by $58.8 million; trading assets also shifted from a $96.0 million loss to a $4.7 million gain.
- Nine-month GAAP results swung from $2.701 billion of net income to a $184.0 million loss. The main drivers were a $1.5 billion net loss on swaps and $779.3 million of losses on swap terminations, versus $1.4 billion of unrealized swap gains and smaller termination losses in 2013. Lower investment-sale gains and losses on interest-only MBS and trading assets also weighed on comparisons.
- Average earning assets for the first nine months fell to $84.6 billion from $111.1 billion, while average asset yield increased to 3.13% from 2.58%. Economic funding cost rose to 1.95% from 1.58%, and economic net interest income declined.
- Agency MBS fair value increased to $81.5 billion from $70.4 billion at year-end. Net unrealized losses on available-for-sale assets narrowed to $967.8 million from $2.749 billion, contributing to higher reported book value.
- Common dividends declared fell to $0.90 per share for the first nine months from $1.20 in 2013. Q3 declared dividend was $0.30 per share.
- Annaly ceased RCap’s U.S. Treasury, derivatives and certain securities-borrowed-and-loaned trading activities in January 2014. A $399.5 million commercial mortgage securitization closed in January; $260.7 million of investment-grade bonds were issued.
Outlook, commentary and risks
- No specific earnings or dividend guidance was provided. Management said it maintained the size of its Agency MBS portfolio in Q3 and remained cautious as the Federal Reserve ended its asset-purchase program in October 2014. At the time of filing, management noted market expectations for federal funds rate increases beginning around mid-2015.
- Management’s modeled parallel rate shocks showed economic net interest income falling 28.0% under a 75-basis-point decline, but rising 2.7% under a 75-basis-point increase. A 75-basis-point increase implied a 1.8% decline in portfolio value, or 12.3% of NAV. A 25-basis-point widening in MBS spreads implied a 1.3% portfolio-value decline, or 8.7% of NAV. These are estimates based on assumptions, not forecasts.
- Key risks include interest-rate, yield-curve, MBS-spread and prepayment movements; repo refinancing and margin calls; collateral and counterparty exposure; and credit risk in commercial real estate and corporate debt. The filing reports $28.5 million of CRE loans in defaulted-recovery status, including one nonaccrual loan, and no CRE loan-loss allowance at quarter-end.
- Approximately 98% of debt consisted of borrowings collateralized by Investment Securities. Management said it seeks to retain unused borrowing capacity and expects continued reliance on repo financing, while considering term financing and securitization.
- Derivative agreements may allow termination after specified events, including equity declines, loss of REIT status, leverage-limit breaches or NYSE delisting. The maximum termination amount for affected derivatives in a net liability position was approximately $660 million and was fully collateralized at quarter-end.
- A one-time $23.8 million payment by FIDAC to Chimera to resolve issues raised in derivative demand letters reduced Q3 other income; management excluded it from core earnings. Routine legal matters were not expected by management to have a material effect, and no contingency accrual was recorded.
- After quarter-end, on November 5, 2014, Annaly amended its management agreement: the term runs through December 31, 2016 with automatic two-year renewals, and termination notice periods changed from 180 days to generally one year. Other terms remained unchanged.
Important facts for investors to verify
- Review the reconciliation and assumptions behind non-GAAP core earnings and economic net interest income, and distinguish them from GAAP results.
- Track repo maturities, collateral haircuts, unencumbered liquidity and margin-call exposure, especially given the high leverage and pledged-asset base.
- Assess the 2015 maturities of the 4% and 5% convertible notes, potential repayment or conversion, and related dilution.
- Monitor swap portfolio size, termination costs, collateral requirements and the sensitivity of book value and earnings to rates and MBS spreads.
- Evaluate the sustainability of common dividends against REIT taxable income and recurring earnings; declared dividends and GAAP earnings may differ.
- Follow credit performance and recovery prospects of CRE loans, including the nonaccrual loan, and assess the impact of the management-agreement amendment on governance and termination flexibility.