Orchid Island Capital, Inc. — 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. The filing is an annual report, not a standalone fourth-quarter filing; quarterly figures below are for the three months ended December 31, 2016. Orchid is an externally managed mortgage REIT investing primarily in agency residential mortgage-backed securities (RMBS), financed mainly through short-term repurchase agreements.
Financial performance and position
| Metric | 2016 | 2015 |
|---|---|---|
| Interest income | $87.1 million | $68.8 million |
| Interest expense | $15.6 million | $7.3 million |
| Net interest income | $71.5 million | $61.5 million |
| Net income | $2.0 million; $0.08 per share | $1.1 million; $0.05 per share |
| Dividends declared per share | $1.68 | $1.92 |
| Average RMBS yield | 3.75% | 3.52% |
| Average funding cost, GAAP | 0.72% | 0.41% |
| Economic net interest spread | 2.58% | 2.94% |
- Fourth quarter: Interest income was $25.1 million, net interest income was $20.1 million, and net loss was $20.4 million, or $0.72 per share. Portfolio and derivative losses totaled $38.0 million.
- Valuation and earnings: Full-year RMBS and derivative losses were $60.5 million, including $54.1 million in unrealized RMBS losses. These losses substantially offset higher net interest income.
- Balance sheet at year-end: RMBS fair value was $3.02 billion; total assets were $3.14 billion; repurchase-agreement borrowings were $2.79 billion; total liabilities were $2.81 billion; and stockholders’ equity was $332.8 million. Ending leverage, measured as liabilities to equity, was 8.4:1.
- Book value: $10.10 per common share, down from $11.64 at December 31, 2015. The portfolio’s modeled effective duration was 4.579, excluding funding-cost hedges.
- Liquidity and cash flow: Cash and cash equivalents were $73.5 million, with approximately $49.9 million of unpledged securities. Operating cash flow was $47.0 million; investing cash flow was negative $919.7 million and financing cash flow was positive $888.9 million. Short-term repo obligations had a 22-day weighted-average remaining maturity and a 5.6% weighted-average collateral haircut.
- Portfolio composition: 95.1% of RMBS fair value was pass-through securities and 4.9% structured securities. Fixed-rate RMBS represented 93.5% of the portfolio. Fannie Mae securities were 73.7%, Freddie Mac 26.0%, and Ginnie Mae 0.3%.
Material changes versus prior year
- RMBS fair value increased to $3.02 billion from $2.16 billion, while repurchase borrowings rose to $2.79 billion from $1.80 billion. Growth reflected equity issuance and leveraged investment of proceeds.
- Interest income increased 27%, but interest expense more than doubled. The average GAAP funding cost rose 31 basis points to 0.72%; the economic funding cost, including attributed hedge effects, rose to 1.17% from 0.58%.
- Net income increased modestly, but remained low relative to the $1.68 per-share dividend declared. The 2016 dividend was reduced from $1.92 per share in 2015; the filing says 9% of the 2016 distributions subject to 2016 tax treatment was return of capital.
- Higher rates late in the year contributed to lower asset values and book value. The modeled impact of a parallel 100-basis-point rate increase at year-end was a 2.20% decline in portfolio value and a 19.98% decline relative to equity, including hedges; estimates depend on model assumptions.
- The company issued 11.17 million shares in 2016 for net proceeds of $118.3 million; shares outstanding increased from 21.75 million to 32.96 million. No common shares were repurchased in 2016.
- Following an FHFA rule, the company repaid $187.5 million of FHLB advances and replaced them with repo funding; it reported no remaining FHLB advances at year-end.
Outlook, risks and other notable items
- Management described a sharp rise in rates after the November 2016 U.S. election and the Federal Reserve’s December rate increase. It expected higher rates to slow mortgage prepayments, potentially supporting near-term portfolio earnings, but warned that further rate increases or funding-cost increases could pressure asset values, net interest income and earnings.
- Management identified uncertainty around Federal Reserve reinvestment of mortgage securities and possible changes to Fannie Mae and Freddie Mac, including housing-finance reform, as potential material market influences. The filing provides no quantified earnings or dividend guidance.
- Principal risks include rate and spread volatility, prepayment and extension risk, leverage, short-term refinancing and margin-call exposure, hedge effectiveness and counterparty risk, and structured-security valuation and liquidity. Agency guarantees protect principal and interest payments, not market value.
- The company intended to continue monthly distributions but set no minimum distribution and gave no assurance of future payments. REIT status generally requires distribution of at least 90% of REIT taxable income, which differs from GAAP income.
- Orchid relies on its affiliated external manager, Bimini Advisors. The related-party management agreement provides for non-performance-based fees and a termination fee generally equal to three times average annual management fees if terminated without cause.
- Auditors issued an unqualified opinion on the financial statements. Management concluded disclosure controls and internal control over financial reporting were effective at year-end. The company reported no material pending legal proceedings, no material capital-expenditure commitments and no off-balance-sheet arrangements.
Important facts for investors to verify
- Review the audited statements and notes for the drivers of the fourth-quarter $38.0 million portfolio and derivative losses, and the sensitivity of reported results to fair-value estimates.
- Assess the sustainability of the dividend against recurring net interest income, GAAP earnings, taxable income, and the use of return-of-capital distributions.
- Monitor book value, repo leverage, collateral haircuts, liquidity, and the short maturity profile of borrowings, particularly under rate or spread shocks.
- Examine the effect of further rate increases on funding costs, hedges, prepayments and asset duration; the filing’s sensitivity scenarios are model-based, not forecasts.
- Consider equity dilution from the at-the-market program: $15.0 million remained available for issuance at year-end under the July 2016 agreement.
- Review the affiliated manager relationship, fee structure and termination provisions, as well as continuing REIT and Investment Company Act exemption compliance.