Business context and reporting period
Annaly Capital Management, Inc. is an externally managed REIT investing primarily in Agency mortgage-backed securities (MBS), with residential-credit, commercial-real-estate and middle-market corporate-debt businesses. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2016; balance-sheet comparisons are with December 31, 2015.
Financial results and condition
- Quarterly earnings: GAAP net loss was $278.5 million, or $0.32 per common share, versus net income of $900.1 million, or $0.93 per share, in Q2 2015. Six-month net loss was $1.147 billion, or $1.28 per share, versus income of $423.6 million, or $0.41 per share.
- Interest income and margins: Q2 net interest income fell to $304.4 million from $511.2 million; six-month net interest income fell to $545.1 million from $900.9 million. Q2 net interest margin was 1.15% versus 2.06%; core net interest margin, a non-GAAP measure, was 1.54% versus 1.70%. The average cost of interest-bearing liabilities rose to 1.68% from 1.59% for the quarter.
- Core earnings: Non-GAAP core earnings were $282.2 million, or $0.29 per share, in Q2, versus $331.5 million, or $0.33, a year earlier. Six-month core earnings were $573.9 million, or $0.58 per share, versus $673.4 million, or $0.67.
- Primary earnings driver: Q2 realized and unrealized losses were $523.8 million, including $373.2 million of unrealized interest-rate-swap losses; the comparable 2015 quarter had $440.5 million of gains, including $700.8 million of unrealized swap gains. Six-month swap losses were $1.743 billion. Management attributed the deterioration mainly to lower forward rates and reduced interest income.
- Cash flow: For the six months, operating activities provided $1.866 billion, investing activities provided $58.3 million, and financing activities used $958.2 million. Cash and cash equivalents ended at $2.735 billion, up from $1.769 billion at year-end.
- Balance sheet and capital: Assets were $77.7 billion, up from $75.2 billion; total liabilities were $66.2 billion and total stockholders’ equity was $11.55 billion. Common book value was $11.50 per share. Reported debt-to-equity leverage was 5.3:1 and economic leverage was 6.1:1; the capital ratio was 13.2%.
- Debt and liquidity: Repurchase agreements totaled $53.9 billion; other secured financing was $3.6 billion and securitized debt was $3.7 billion. Repo weighted-average rate was 1.02%, with 129 days’ weighted-average remaining maturity. The filing reports $7.67 billion of unencumbered financial assets; its broader liquid-assets measure was 91.79% of total assets and includes assets already pledged as collateral.
- Portfolio and distributions: Agency MBS were $64.9 billion; commercial real-estate debt investments at fair value were $4.4 billion. Common dividends declared were $0.30 per share for Q2 and $0.60 for the first half, unchanged from the comparable 2015 periods.
Material changes versus prior comparable periods
- Interest income declined 27% in Q2 to $457.1 million and 26% for the first half to $845.3 million. Management cited lower average residential securities balances and yields, and greater premium amortization as projected long-term prepayments increased; commercial portfolio income partly offset the decline.
- Q2 core earnings per share declined to $0.29 from $0.33, while the GAAP result swung from profit to loss, chiefly because of the change in swap fair values.
- Net unrealized gains on available-for-sale securities shifted to $1.117 billion at June 30 from a $377.6 million net unrealized loss at year-end. Total stockholders’ equity nevertheless declined from $11.90 billion to $11.55 billion, reflecting the period’s losses and distributions.
- Residential MBS fair value declined to $64.9 billion from $65.7 billion, while commercial real-estate debt investments at fair value rose to $4.4 billion from $2.9 billion. Repo borrowings fell to $53.9 billion from $56.2 billion, while other secured financing increased.
Outlook, commentary, risks and unusual items
- Management described a cautious portfolio stance amid low rates, market uncertainty and prepayment concerns, and said it continued improving collateral quality while controlling leverage. It gave no specific earnings or dividend guidance.
- Management noted that Q2 interest rates fell about 15–35 basis points; the 10-year Treasury yield was 1.47% at June 30. Experienced CPR was 12.7% and projected long-term CPR was 13.0%, compared with 7.7% projected a year earlier. Faster prepayments can accelerate premium amortization and reduce income.
- Illustrative sensitivity tests, assuming instantaneous rate shocks and no management action, projected that a 75-basis-point rate increase would raise 12-month economic net interest income 26.2% but reduce portfolio value 0.9%; a 75-basis-point decrease would reduce income 19.9%. A 25-basis-point widening in MBS spreads was estimated to reduce portfolio value 1.3%, or 7.7% of NAV. Actual results may differ materially.
- Key risks include repo funding availability and margin calls, collateral values, interest-rate and spread changes, prepayments, derivative counterparty performance, credit exposure in non-Agency and commercial assets, and REIT and regulatory compliance. Derivatives with specified termination triggers had about $3.0 billion of net liabilities; the filing says this amount was fully collateralized.
- Hatteras acquisition: The acquisition closed July 12, 2016, after quarter-end, for approximately $1.5 billion of consideration to common shareholders, including 93.9 million Annaly shares. Hatteras preferred shares converted into Annaly Series E preferred shares. Management expects portfolio complementarity and efficiency opportunities, but warned that benefits may not be realized and integration may disrupt operations. Annaly reported $2.2 million of acquisition transaction costs in the first half; Hatteras paid its former manager a $45.4 million termination fee. The acquired business and consideration are not reflected in the June 30 balance sheet.
- All CRE loans were reported performing, with no impaired, nonaccrual or defaulted loans and no loan-loss allowance. The company reported no material legal proceedings or contingencies. Controls were assessed as effective.
Important facts for investors to verify
- Reconcile GAAP losses to non-GAAP core earnings, including the treatment of swap marks, dollar-roll income and premium-amortization adjustments.
- Review post-acquisition filings for Hatteras purchase accounting, integration costs, servicing/MSR exposure, share dilution and effects on book value and earnings.
- Assess dividend sustainability against taxable income and recurring earnings; core earnings are a non-GAAP measure and are not equivalent to cash available for distribution.
- Monitor repo refinancing, collateral and margin requirements, actual unencumbered liquidity, and the size and collateralization of derivative liabilities.
- Track actual prepayment speeds, MBS spread movements, hedge performance and credit quality in commercial and residential-credit portfolios.