Business context and reporting period
Annaly Capital Management, Inc. (NYSE: NLY) filed this Form 10-K for the fiscal year ended December 31, 2018. Annaly is an externally managed REIT investing in residential and commercial real estate-related assets and middle-market corporate loans. Its largest business remains Agency mortgage-backed securities (MBS); it also invests in residential credit, commercial real estate, mortgage servicing rights (MSRs) and corporate debt.
On September 7, 2018, Annaly completed its acquisition of MTGE Investment Corp., expanding its portfolio and adding healthcare real estate. The deal included $450.3 million cash and $455.9 million in common equity for MTGE common shareholders, plus $55.0 million of preferred stock issued in exchange for MTGE preferred shares.
Financial results and position
| Metric | 2018 | 2017 |
|---|---|---|
| Interest income | $3.333 billion | $2.493 billion |
| Interest expense | $1.898 billion | $1.008 billion |
| Net interest income | $1.435 billion | $1.485 billion |
| GAAP net income | $54.1 million | $1.569 billion |
| GAAP net income available to common shareholders | Loss of $74.9 million; loss of $0.06 per share | $1.460 billion; $1.37 per share |
| Core earnings excluding premium amortization adjustment (non-GAAP) | $1.575 billion; $1.20 per share | $1.409 billion; $1.22 per share |
| Net interest margin excluding premium amortization adjustment (non-GAAP) | 1.52% | 1.51% |
| Net interest spread excluding premium amortization adjustment (non-GAAP) | 1.13% | 1.19% |
| Total assets / total equity | $105.8 billion / $14.1 billion | $101.8 billion / $14.9 billion |
| Common book value per share | $9.39 | $11.34 |
| Common dividend declared per share | $1.20 | $1.20 |
Cash from operating activities was $2.622 billion; investing activities used $908.4 million and financing activities used $684.4 million. Cash and cash equivalents rose by $1.029 billion to $1.736 billion at year-end. These cash-flow totals include substantial securities and financing activity and should not be read as recurring free cash flow.
At year-end, repurchase agreements totaled $81.1 billion and total indebtedness was $89.2 billion. Debt-to-equity leverage was 6.3:1 and economic leverage was 7.0:1, up from 5.7:1 and 6.6:1, respectively. Annaly’s stated economic leverage guideline is generally no greater than 10:1. The company reported $7.7 billion of unencumbered financial assets; its reported liquid assets totaled $97.7 billion, most of which were pledged as collateral.
Material changes versus the prior comparable period
- GAAP results deteriorated sharply: 2018 realized and unrealized losses were $1.163 billion, versus gains of $199.5 million in 2017. Annaly recorded $1.124 billion of net losses on investment disposals, primarily after selling $45.6 billion of residential securities, compared with $3.9 million of disposal losses in 2017.
- Net interest income declined $50.1 million despite higher interest income, as interest expense rose $889.5 million amid higher funding costs and larger average liabilities. Average cost of interest-bearing liabilities increased to 2.04% from 1.75%.
- Core earnings excluding the premium amortization adjustment increased to $1.575 billion from $1.409 billion, but declined per average common share to $1.20 from $1.22. This non-GAAP measure is not a substitute for GAAP earnings, and Annaly changed its core-earnings definition beginning in the third quarter of 2018.
- Common book value per share fell to $9.39 from $11.34. Accumulated other comprehensive loss widened to $1.980 billion from $1.126 billion, largely reflecting lower fair values on available-for-sale investments. Annaly said the declines in Agency MBS values reflected market conditions, not asset credit quality, and reported no other-than-temporary impairment.
- Annaly issued 154.2 million common shares during 2018, including shares for the MTGE acquisition, a public offering and its at-the-market program. The larger share count and additional preferred dividends affect per-share comparisons.
Outlook, commentary, risks and unusual items
- Management said it expects growth in its three credit businesses to continue in 2019, while describing the broader credit sector as fully valued and investment selection as highly selective. Higher rates also prompted rotation toward higher-coupon Agency MBS.
- The Federal Reserve raised its target rate four times in 2018; mortgage spreads widened and market volatility increased. Annaly’s disclosed sensitivity analysis estimated that a 50-basis-point rate increase would raise projected 12-month economic net interest income by 3.2% but reduce portfolio value by 0.6%. A 25-basis-point MBS spread widening was estimated to reduce portfolio value by 1.5%. These are model estimates assuming no management response, not forecasts.
- Key risks include leverage and short-term repo dependence, collateral and margin calls, interest-rate and spread movements, prepayment and reinvestment risk, credit losses in non-Agency and commercial assets, counterparty exposure, and changes to regulation or REIT and Investment Company Act qualification. The filing also flags LIBOR’s expected replacement by SOFR and the risk that the transition complicates asset-liability hedging.
- Year-end results included $58.3 million of MTGE transaction costs and a $44.5 million excess of consideration over the fair value of acquired net assets, recognized in other income (loss). G&A totaled $329.9 million, including $65.4 million of transaction costs related to MTGE and residential-loan securitizations.
- Annaly recorded a $3.5 million loan-loss provision on a commercial mezzanine loan. It reported no pending material legal proceedings or material contingencies at December 31, 2018.
- Subsequent to year-end, Annaly completed a common-stock offering in January 2019 for approximately $840.1 million before offering expenses and closed a $393.9 million-face-value residential-loan securitization.
Most important facts for investors to verify
- Whether the sharp GAAP loss and book-value decline reflect a lasting change in portfolio economics or primarily 2018 market marks and asset-sale losses; compare GAAP results with the company’s revised non-GAAP core earnings.
- Current repo funding terms, counterparty concentration, collateral haircuts, unencumbered assets and capacity to meet margin calls under adverse market conditions.
- Whether credit-portfolio growth, including MTGE-acquired assets and middle-market loans, is producing returns commensurate with its added credit and liquidity risks.
- How borrowing costs, mortgage spreads, prepayments and hedges affect net interest income, and whether the disclosed sensitivity estimates remain relevant as the portfolio changes.
- The sustainability of the $1.20 annual common dividend relative to taxable income, cash generation, preferred dividends and future capital needs; the filing does not establish a minimum dividend.
- The timing and terms of the FHLB captive-insurer membership sunset in February 2021, and the potential funding impact if continued access is unavailable.