Armour Residential REIT, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Financial statements are unaudited. Armour is an externally managed mortgage REIT investing primarily in residential mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae; these Agency securities represented 100% of its portfolio at quarter-end.
Financial performance and position
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Interest income, net of premium amortization | $116.7m | $39.7m | $265.7m | $82.3m |
| Net interest income | $97.5m | $36.2m | $228.4m | $75.1m |
| Net income (loss) | $54.9m | ($34.5m) | $106.6m | ($33.1m) |
| Net income (loss) available to common | $54.1m | ($34.5m) | $105.6m | ($33.1m) |
| Basic and diluted EPS | $0.20 | ($0.44) | $0.54 | ($0.63) |
| Common dividends per share | $0.30 | $0.36 | $0.92 | $1.06 |
- Margins: Q3 asset yield was 2.70%, cost of funds 0.89%, and net interest margin 1.82%, down from 2.15% in Q2 2012 and 2.18% in Q3 2011. Repurchase-agreement interest expense was 0.45% for Q3.
- Derivatives and comprehensive income: Q3 other loss was $35.3m, including $18.9m realized and $31.5m unrealized derivative losses, partly offset by $15.1m realized securities gains. Nine-month derivative losses totaled $125.3m. Other comprehensive income was $235.0m in Q3 and $353.9m for nine months, primarily reflecting unrealized gains on available-for-sale securities; those changes are not the same as realized earnings.
- Balance sheet at September 30: Total assets were $23.52bn, including $22.11bn of Agency securities; repurchase agreements were $19.83bn, total liabilities $21.07bn, and stockholders’ equity $2.44bn. Cash was $727.3m and restricted cash $237.8m. The portfolio’s amortized cost was $21.71bn versus fair value of $22.11bn.
- Debt and liquidity: Borrowings were approximately 8.12 times equity, within the company’s stated typical target of 6–10 times. Repo weighted-average maturity was 39 days, contractual rate 0.43%, and haircut 4.8%. About $9.93bn of repo borrowings repriced within 30 days. Management said available liquidity and capital resources were sufficient for anticipated short-term needs, while warning that margin calls and reduced financing access could impair that capacity.
- Cash flow, nine months: Operating cash flow was $193.8m; investing cash outflow was $15.56bn; financing cash inflow was $15.84bn. Net cash increased $474.9m to $727.3m. Financing included $1.50bn net common-equity proceeds, $43.0m net preferred proceeds and a $14.49bn net increase in repo financing.
Material changes from comparable periods
- The portfolio expanded substantially: Agency securities fair value rose to $22.11bn from $5.39bn at December 31, 2011. The company raised approximately $1.5bn of net common equity and $43.3m of net preferred equity during the first nine months, with common shares outstanding increasing to 309.0m from 95.4m at year-end 2011.
- Higher interest income and net interest income reflected the larger equity-funded, repo-financed portfolio. The company cautioned that results per share may take time to reflect a full run-rate because of continued equity issuance.
- The common dividend declined from $0.12 per month during 2011 to $0.10 per month from April through September 2012. After quarter-end, the company announced an expected Q4 common dividend of $0.09 per share. The Series A preferred stock carries an 8.25% annual dividend rate.
- Interest-rate swap notional increased to $8.69bn from $2.77bn at year-end 2011; the company also entered into $1.05bn of swaptions. Fixed-rate securities rose to 89.2% of the portfolio from 47.8% at year-end.
Outlook, risks and notable items
- The Federal Reserve’s QE3 program—purchases of $40bn of Agency securities monthly, alongside existing programs—was expected to support high asset prices and low long-term rates. Management said these conditions were compressing spreads and making reinvestment and hedging more challenging. No earnings or margin guidance was provided.
- Key risks include short-term repo funding against longer-duration assets; rising rates or wider spreads increasing funding costs, reducing asset values and triggering collateral calls; prepayments accelerating amortization of securities purchased at premiums; and hedge positions failing to offset asset and liability movements. A parallel 100-basis-point rate increase was modeled to raise projected net interest income by 9.01% but reduce projected portfolio value including derivatives by 0.46%; a 100-basis-point decline was modeled to reduce those measures by 24.79% and 2.10%, respectively. These are model estimates, not forecasts.
- All derivative fair-value changes run through GAAP earnings because the company did not elect cash-flow hedge accounting. This can make reported earnings volatile even where management intends the hedges to work economically.
- Other uncertainties include possible GSE and housing-finance reform, regulatory changes affecting the company’s Investment Company Act exemption, LIBOR-related developments, and uncertainty over CFTC relief from commodity-pool-operator registration requirements for directors using swaps.
- Management fees are based on gross equity raised rather than portfolio performance; fees were $5.5m in Q3 and $13.4m for nine months, versus $2.2m and $4.4m, respectively, in 2011. The filing also describes potential conflicts involving the external manager, its affiliates and JAVELIN.
- A repurchase-agreement counterparty bankruptcy contributed a $1.1m loss included in the reported nine-month securities-sale gain, alongside $1.0m of other income related to counterparty non-performance. No other-than-temporary securities impairment was recorded. The company reported no pending litigation and no material indemnification liabilities recorded.
- After quarter-end, the board increased authorized common shares to 1bn and preferred shares to 50m, effective October 31, 2012, without a stockholder vote. Disclosure controls were reported effective, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether the narrowing net interest margin and lower common dividend remain sustainable as asset yields, financing costs and prepayments change.
- Repo rollover, counterparty concentration, haircuts and available unpledged liquidity relative to potential margin calls.
- Portfolio and book-value sensitivity to interest rates, spreads and prepayment assumptions, including the effectiveness and accounting volatility of hedges.
- The impact of continued common-share issuance, the new authorized-share capacity, preferred dividends and the external manager’s equity-based fee structure on common-stockholder returns.
- Developments in GSE policy, QE3, CFTC exemption status and other regulatory changes that could affect financing, hedging or the investment strategy.