Annaly Capital Management, Inc. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018. Annaly is an externally managed REIT investing in residential and commercial real estate-related assets and middle-market loans. Financial comparisons below are against the corresponding 2017 periods unless stated otherwise.
Financial results and key metrics
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Interest income | $816.6 million | $622.6 million | $2,472.9 million | $1,747.7 million |
| Interest expense | $501.0 million | $268.9 million | $1,311.1 million | $689.6 million |
| Net interest income | $315.6 million | $353.6 million | $1,161.8 million | $1,058.1 million |
| Net income | $385.4 million | $367.3 million | $2,309.0 million | $822.2 million |
| Net income available to common stockholders | $353.9 million | $337.2 million | $2,212.5 million | $745.4 million |
| GAAP diluted EPS | $0.29 | $0.31 | $1.88 | $0.72 |
| Core earnings excluding PAA, non-GAAP | $389.7 million; $0.30/share | $353.5 million; $0.30/share | $1,157.8 million; $0.90/share | $1,022.0 million; $0.91/share |
Q3 net interest margin was 1.49% (1.50% excluding premium amortization adjustment, or PAA), versus 1.33% (1.47% excluding PAA) a year earlier. Net interest spread was 1.13% versus 0.97%; excluding PAA, it was 1.14% versus 1.15%. For the first nine months, net interest margin was 1.65% versus 1.34%, and net interest spread was 1.27% versus 0.99%. The company’s non-GAAP measures have limitations and are not substitutes for GAAP results.
Balance sheet at September 30, 2018: Total assets were $106.0 billion, total liabilities $91.0 billion, and total equity $15.0 billion. Securities totaled $91.3 billion; loans were $4.2 billion. Repurchase agreements were $79.1 billion, other secured financing $4.1 billion, securitization debt $3.8 billion, and mortgages payable $0.5 billion. Common book value per share was $10.03, compared with $11.42 at September 30, 2017. Accumulated other comprehensive loss was $3.8 billion, versus $1.1 billion at December 31, 2017, reflecting substantial available-for-sale securities losses.
Leverage and liquidity: Debt-to-equity leverage was 5.9:1 and economic leverage 6.7:1, versus 5.7:1 and 6.6:1, respectively, at year-end 2017. The capital ratio was 12.6%, versus 12.9% at year-end. Cash and cash equivalents were $1.08 billion. Unencumbered financial assets totaled $8.36 billion; management reported liquid assets equal to 97.66% of encumbered and unencumbered financial assets. Repurchase agreements had a 55-day weighted average maturity; the weighted average remaining maturity of repurchase agreements and other secured financing combined was 94 days.
Cash flow for the first nine months: Operating activities provided $3.02 billion, investing activities used $0.42 billion, and financing activities used $2.23 billion. Cash increased $376.2 million to $1.08 billion. These cash flows include substantial investment turnover and derivative receipts/payments; they should not be read as operating cash flow for a conventional nonfinancial business.
Common dividends declared were $0.30 per share for Q3 and $0.90 per share for the nine-month period, unchanged from the comparable 2017 periods.
Material changes and unusual items
- On September 7, Annaly completed its acquisition of MTGE Investment Corp. for $450.3 million cash and $455.9 million in common equity consideration for MTGE common shareholders; MTGE preferred shares were exchanged for $55.0 million of Annaly Series H preferred stock. The acquisition added assets and increased leverage. It was accounted for as an asset acquisition.
- The acquisition and residential-loan securitization activity drove $60.1 million of Q3 transaction and nonrecurring costs, including $58.3 million of MTGE transaction costs. Annaly also recognized $44.5 million of excess consideration over acquired net asset fair value in other income.
- Q3 GAAP net income increased modestly, but EPS declined to $0.29 from $0.31 as the weighted-average common share count rose. The share count increase reflected equity issuance, including shares issued for MTGE.
- Q3 net interest income fell to $315.6 million from $353.6 million as funding expense increased; higher interest income and favorable swap interest contributions partly offset this. Core earnings excluding PAA per share were unchanged at $0.30.
- Reported gains included $417.2 million of unrealized gains on interest rate swaps in Q3 and $1.74 billion for the nine-month period. These were partly offset by losses on investment sales: $324.3 million in Q3 and $376.9 million for nine months. Nine-month net realized and unrealized gains were $1.34 billion, compared with a $159.7 million loss in 2017.
- Available-for-sale securities’ fair-value losses were recorded principally in other comprehensive income, not current earnings. Management attributed Agency MBS declines to market conditions, reported no other-than-temporary impairment, and said it intended and expected to be able to hold the securities through recovery.
- Agency MBS spreads widened modestly in Q3; interest rates continued to rise. The 10-year Treasury rate was 3.06% at September 30, 2018, versus 2.41% at year-end 2017. Management described broader credit markets as fully valued and said it remained selective in adding credit assets.
Outlook, risks and contingencies
The filing provides no specific earnings or dividend guidance. Management said it expected to continue financing residential securities largely through repurchase agreements, with other financing structures also available. Its stated general expectation was to keep economic leverage below 10:1. The company described MTGE’s portfolio as complementary and cited potential efficiency and growth opportunities.
Key exposures include interest-rate and mortgage-spread movements, prepayment speeds, financing availability and terms, collateral values and margin calls, liquidity, credit losses in non-Agency and commercial assets, counterparty performance, and regulatory and REIT-compliance requirements. Management’s September 30 sensitivity analysis, assuming no responsive management action, estimated that a 75-basis-point rate rise would reduce portfolio value by 1.2% and NAV by 8.6%, while a 75-basis-point rate decline would reduce projected economic net interest income by 12.2%. A 25-basis-point widening in mortgage spreads was estimated to reduce portfolio value by 1.6% and NAV by 11.3%. Actual outcomes could differ materially.
Management reported no material pending legal proceedings or material contingencies, and no material change to previously disclosed risk factors. It stated that disclosure controls were effective and that no material change in internal control over financial reporting occurred during the quarter. Truman Insurance Company’s Federal Home Loan Bank membership was subject to a sunset provision expiring in February 2021. A subsequent event was the October 31 closing of the OBX 2018-EXP2 residential-loan securitization, with a $384 million face value.
Most important facts for investors to verify
- How much of reported earnings and equity performance reflects recurring spread income versus derivative fair-value movements, investment-sale losses, and other market-value changes.
- Whether funding costs, repo maturities, haircuts, collateral demands, and available unencumbered assets remain manageable as rates and mortgage spreads change.
- The drivers and sustainability of the decline in book value per share, including the accumulated available-for-sale securities losses and any subsequent market recovery or deterioration.
- MTGE’s integration, acquired portfolio performance, realized cost savings, and the effect of transaction costs and increased share count on per-share results.
- Credit quality and concentration in commercial real estate, residential credit, corporate debt, and residential whole loans; the filing reports two commercial loans rated Substandard, though management expected contractual repayment.
- The definitions and comparability of revised non-GAAP core earnings measures, which changed in Q3 2018 and were not recast for prior periods.