Annaly Capital Management, Inc. — Q1 2012 Form 10-Q
Reporting period: Quarter ended March 31, 2012. Annaly is a mortgage REIT whose primary business is financing a leveraged portfolio of agency mortgage-backed securities (MBS); subsidiaries also provide investment-management, brokerage, and other financial services. Unless stated otherwise, dollar amounts below are in U.S. dollars.
Financial performance and condition
| Metric | Q1 2012 | Comparable period / change |
|---|---|---|
| Interest income | $854.9 million | $844.0 million in Q1 2011, up about 1% |
| GAAP net interest income | $721.6 million | $728.6 million in Q1 2011, down about 1% |
| Economic net interest income, including swap interest | $502.2 million | $522.4 million in Q1 2011, down $20.2 million |
| Net income | $901.8 million | $699.9 million in Q1 2011, up $201.9 million |
| Net income available to common shareholders | $897.9 million | $695.6 million in Q1 2011 |
| Basic / diluted EPS | $0.92 / $0.89 | Unchanged from Q1 2011 |
| Economic net interest spread | 1.71% | 2.17% in Q1 2011 |
| Yield on average interest-earning assets / cost of interest-bearing liabilities | 3.23% / 1.52% | 3.79% / 1.62% in Q1 2011 |
| Annualized return on average equity | 22.73% | 24.56% in Q1 2011 |
| Cash and cash equivalents | $932.8 million | $994.2 million at December 31, 2011 |
| Total assets / stockholders’ equity | $120.3 billion / $15.9 billion | $109.6 billion / $15.8 billion at December 31, 2011 |
| Repurchase agreements | $91.7 billion | $84.1 billion at December 31, 2011 |
| Debt-to-equity ratio | 5.8:1 | 5.4:1 at December 31, 2011; management generally expects below 12:1 |
Net income growth was driven principally by higher unrealized gains on interest-rate swaps and interest-only agency MBS, together with larger realized gains on securities sales. The filing reports $341.6 million of unrealized swap gains and $30.9 million of unrealized gains on interest-only agency MBS for Q1 2012. These valuation gains boosted GAAP income but are distinct from recurring spread income.
Average interest-earning assets rose to $105.7 billion from $89.2 billion a year earlier, while their yield declined. Economic interest expense, including swap interest, increased to $352.7 million from $321.6 million, largely reflecting higher average liabilities. The reported economic spread narrowed by 46 basis points year over year.
Operating cash flow was $4.99 billion, investing cash flow was negative $7.81 billion, and financing cash flow was $2.76 billion. Cash declined by $61.4 million during the quarter. These cash-flow totals include substantial short-term matched-book financing and securities transactions and should not be read as ordinary operating cash generation.
At quarter-end, agency MBS fair value was $110.3 billion. Repurchase agreements had a 0.49% weighted-average rate before the filing’s broader cost-of-funds measures, a 127-day weighted-average remaining maturity, and were supported by approximately $98.7 billion of pledged collateral; the disclosed weighted-average haircut was about 5%, with an approximately $8.9 billion excess collateral cushion.
Material changes versus the prior comparable period
- Net income rose about 29%, but basic and diluted EPS were unchanged at $0.92 and $0.89, respectively, as average common shares outstanding increased substantially.
- Economic spread fell from 2.17% to 1.71%; the average asset yield fell 56 basis points, partly offset by a 10-basis-point reduction in funding cost.
- Agency MBS fair value increased to $110.3 billion from $104.3 billion at year-end 2011. The portfolio’s average CPR was 19%, down from 22% in Q4 2011 but above 17% in Q1 2011.
- Common dividends declared were $0.55 per share, compared with $0.62 in Q1 2011. The Q1 2012 dividend was paid April 26, 2012.
- The Series B cumulative convertible preferred stock was converted into common stock; no Series B shares were outstanding at March 31, 2012. Series A preferred stock remained outstanding.
- Compensation and general and administrative expenses rose to $67.9 million from $51.8 million, primarily reflecting higher compensation costs; reported staff increased from 121 to 152 year over year.
Outlook, commentary, and risks
The filing gives no specific earnings or dividend guidance. Management said it expected to continue financing operations primarily through repurchase agreements, sought to preserve unused borrowing capacity, and expected swap pay rates to continue declining as higher-rate swaps matured or were replaced. These are forward-looking statements, not assurances of future results.
- Interest rates and spread risk: Management’s modeled parallel-rate shocks estimated economic net interest income changes of +7.01% at a 75-basis-point decline and -4.17% at a 75-basis-point increase; corresponding portfolio-value changes, including swaps, were +0.96% and -1.75%. The filing cautions that actual results may differ significantly.
- Prepayment and premium-amortization risk: Faster mortgage prepayments can accelerate amortization of the portfolio’s substantial net premium and reduce interest income.
- Funding, collateral, and liquidity risk: Lenders may demand same-day additional collateral after declines in asset values. Annaly reported no repurchase-agreement margin calls it could not meet through March 31, 2012, but sudden rate or prepayment changes could pressure liquidity. Most borrowings were repurchase agreements, and the company had no committed facility requiring lenders to renew them.
- Counterparty exposure: The company reported $538.1 million of exposure to specified European financial counterparties, equal to 0.44% of total assets, and said it did not use credit-default swaps to hedge this exposure.
- Regulatory and REIT risks: Annaly reported compliance with REIT tests and the Investment Company Act exemption at quarter-end. It noted that SEC review of the Section 3(c)(5)(C) exemption could affect its business, with outcomes and timing uncertain.
- Other items: Management said ordinary-course legal matters were not expected to have a material effect and no accrual was required. No other-than-temporary impairment was recorded for the periods presented. The company had authorization to sell up to 125 million common shares through an at-the-market program but made no sales under it in Q1.
Most important facts for investors to verify
- Reconcile recurring economic spread earnings with reported GAAP net income, which benefited materially from unrealized derivative and interest-only MBS gains.
- Track asset yields, funding costs, swap cash payments, CPR, and the effect of premium amortization on future net interest income and dividends.
- Assess repo renewal and margin-call capacity, collateral haircuts, unused borrowing capacity, and exposure to individual financing and swap counterparties.
- Confirm the details and share-count effects of the Series B preferred conversion; conversion amounts are described inconsistently in different parts of the filing.
- Reconcile the interest-rate-swap liability disclosures: the balance sheet and related fair-value tables present amounts that do not consistently agree. Confirm the correct carrying value and period-end comparison in the company’s source filing.
- Monitor the SEC’s review of the mortgage-REIT Investment Company Act exemption and the company’s continued REIT and exemption compliance.