Rithm Capital Corp. quarterly report, Q2 FY2014

Business Context and Reporting Period

This unaudited Form 10-Q was filed by New Residential Investment Corp., the predecessor name of Rithm Capital Corp., for the quarter and six months ended June 30, 2014. The company was an externally managed REIT focused on residential mortgage-related assets, including excess mortgage servicing rights (Excess MSRs), servicer advances, Agency and Non-Agency RMBS, residential mortgage loans and consumer loans. It became independent following its spin-off from Newcastle Investment Corp. on May 15, 2013; therefore, prior-period comparisons are not fully comparable.

Financial Performance and Key Metrics

Metric	Three Months Ended June 30	Six Months Ended June 30
Interest income	$92.7 million in 2014 vs. $23.0 million in 2013	$164.1 million vs. $39.2 million
Net interest income	$56.1 million vs. $20.3 million	$88.6 million vs. $35.6 million
Other income	$177.9 million vs. $98.2 million	$212.9 million vs. $101.0 million
Net income	$182.2 million vs. $109.2 million	$239.1 million vs. $122.3 million
Net income attributable to common stockholders	$123.5 million vs. $109.2 million	$172.3 million vs. $122.3 million
Diluted EPS	$0.44 vs. $0.43	$0.64 vs. $0.48
Dividend declared per share	$0.250 vs. $0.070	$0.425 vs. $0.070

Six-month net income attributable to common stockholders increased approximately 41%, while diluted EPS increased approximately 33%. Growth was partly offset by higher share count, affiliate fees, incentive compensation and income taxes.
Six-month other income included an $82.9 million fair-value gain on servicer advances, a $56.9 million gain on settlement of investments and $31.2 million of combined fair-value gains on Excess MSRs and related equity-method investments.
Core earnings, a non-GAAP measure, were $56.4 million for the quarter and $98.1 million for the six months, compared with $38.3 million and $51.1 million, respectively, in the prior-year periods.

Balance Sheet, Liquidity and Leverage

Total assets were $7.04 billion at June 30, 2014, up from $5.96 billion at December 31, 2013.
Major investments included servicer advances of $3.68 billion, Excess MSRs of $372.4 million held directly and $330.2 million through equity-method investees, real estate securities of $1.46 billion, residential mortgage loans of $517.4 million and consumer-loan investments of $250.0 million.
Cash and cash equivalents were $311.1 million, with restricted cash of $37.3 million.
Total liabilities were $5.23 billion, including $1.82 billion of repurchase agreements and $3.29 billion of notes payable. Total equity was $1.81 billion, including $313.3 million of noncontrolling interests.
Six-month operating cash flow was $27.4 million, investing cash flow was $(1.08) billion and financing cash flow was $1.09 billion, producing a $39.1 million increase in cash.
Available financing capacity was reported at approximately $2.91 billion, subject to eligible collateral and other borrowing conditions. Management stated that liquid assets and expected operating cash flow were sufficient for anticipated near-term requirements, including potential margin calls.
Debt obligations had weighted-average funding costs of approximately 2.54% and weighted-average lives of 1.1 years. Approximately $2.58 billion of debt had contractual maturities from July through December 2014.

Material Changes Versus the Prior Comparable Period

The portfolio expanded substantially, driven primarily by the acquisition of servicer advances beginning in December 2013. Servicer-advance carrying value increased from $2.67 billion at year-end 2013 to $3.68 billion at June 30, 2014.
Residential mortgage loans increased from $33.5 million to $517.4 million, principally from acquisitions of performing and non-performing loan portfolios.
Real estate securities decreased from $1.97 billion to $1.46 billion as the company sold securities while redeploying capital into loans and servicing-related assets.
The company issued approximately 28.75 million common shares in April 2014 for net proceeds of approximately $163.8 million, plus $6.1 million from an executive officer’s purchase. Shares outstanding increased to 282.2 million at June 30, 2014.
Affiliate management fees and incentive compensation increased materially. Six-month management fees and incentive compensation totaled $31.6 million, compared with $3.1 million of comparable post-spin-off affiliate expenses in the prior-year presentation; the prior period also included $4.1 million of fees allocated by Newcastle.
Income tax expense was $21.7 million for the six months, compared with none in the prior-year period, primarily because servicer advances were held through a taxable REIT subsidiary.
The company’s second-quarter net interest spread was 1.17% for Agency ARM RMBS and 5.28% for Non-Agency RMBS, compared with 1.19% and 2.67%, respectively, at March 31, 2014.

Guidance, Outlook, Commentary, Risks and Unusual Items

Management expected continued investment opportunities in MSRs, servicer advances, distressed residential loans and Non-Agency RMBS, but stated that future asset allocation would depend on market conditions, financing availability and risk-adjusted returns. No formal earnings guidance was provided.
Management used a 12.0% weighted-average discount rate to value Excess MSRs in the second quarter, reduced from 12.5%. The company reported that Excess MSR fair value increased approximately $9.6 million during the quarter.
Unusual or non-recurring items included the $39.7 million gain on the sale of the 2009-1 Retained Certificates, a $6.7 million gain on transfers of loans to real estate owned, the $11.3 million loss recognized on one non-performing loan acquisition and a $0.9 million six-month OTTI charge on securities.
Subsequent to quarter-end, the company invested $19.9 million in two additional Excess MSR pools, funded and recovered significant servicer advances, refinanced certain advance facilities, acquired and sold RMBS and increased its net short TBA position by $392.0 million.
Primary risks include valuation sensitivity to prepayment speeds, delinquencies, defaults, recapture rates and discount rates; reliance on Nationstar as servicer and counterparty; reliance on Springleaf for consumer-loan servicing; short-term repo refinancing and margin-call exposure; illiquidity of MSRs and servicer advances; credit losses; and changes in interest rates and credit spreads.
The company reported no material litigation and stated that it was in compliance with debt covenants as of June 30, 2014. Disclosure controls were deemed effective.
The company intended to maintain REIT status and its exclusion from registration under the Investment Company Act, but warned that failure to satisfy technical requirements could materially increase taxes, restrict operations or require asset sales.
On August 5, 2014, the management agreement was amended to exclude unrealized gains and losses, and related deferred tax effects, from the incentive-compensation calculation. The amendment reduced incentive compensation, particularly on the servicer-advance valuation gain.

Investor Verification Checklist

Verify the sustainability of earnings excluding the $82.9 million servicer-advance fair-value gain and other realized or unrealized gains.
Reconcile core earnings to GAAP net income and assess whether cash collections support the declared dividend.
Review servicer-advance recovery rates, future funding commitments, financing maturities and the effect of the 14% targeted return and Nationstar performance-fee structure.
Assess exposure to Nationstar, Springleaf and repo counterparties, including servicing, legal, liquidity and refinancing risks.
Test valuation assumptions for Excess MSRs and servicer advances, particularly prepayment, delinquency, default, recapture and discount-rate assumptions.
Review the approximately $2.58 billion of debt maturing in the second half of 2014 and the availability of replacement financing.
Confirm continued REIT qualification, taxable REIT subsidiary taxes and compliance with the Investment Company Act exclusion.
Consider the limited comparability of 2013 results because the company was not independent for the full prior-year periods.