Business context and reporting period
Annaly Capital Management, Inc. filed this unaudited Form 10-Q for the quarter ended June 30, 2011. The REIT primarily invests, with leverage, in agency mortgage-backed securities (MBS) and agency debentures, financed mainly through repurchase agreements. Its subsidiaries also provide investment advisory, broker-dealer, warehouse-financing and other services.
Financial performance and position
Amounts below are in U.S. dollars; financial statement figures are rounded.
| Metric | Q2 2011 / June 30, 2011 | Comparable period / prior year-end |
|---|---|---|
| Total interest income | $957.1 million | $643.7 million in Q2 2010 |
| GAAP net interest income | $843.7 million | $539.0 million in Q2 2010 |
| Economic net interest income, including swap interest | $627.0 million; 2.45% net interest spread | $363.4 million; 2.16% spread in Q2 2010 |
| Net income (loss) | $120.8 million; $0.14 basic and diluted EPS | $(218.2) million; $(0.40) EPS in Q2 2010 |
| Six-month net income | $820.7 million; $1.03 basic and $1.00 diluted EPS | $62.8 million; $0.10 EPS in first half 2010 |
| Cash and cash equivalents | $401.8 million | $282.6 million at December 31, 2010 |
| Total assets | $100.6 billion | $83.0 billion at December 31, 2010 |
| Repurchase agreements | $78.4 billion; weighted-average rate 1.68% after swaps and average remaining maturity 130 days | $65.5 billion; 1.84% and 127 days at December 31, 2010 |
| Stockholders’ equity | $13.9 billion | $9.9 billion at December 31, 2010 |
- Agency MBS fair value was $96.8 billion, up from $78.4 billion at year-end. MBS and agency debentures had a combined fair value of approximately $97.5 billion.
- Debt-to-equity was 5.7:1, down from 6.7:1 at year-end; management’s stated general target range is 8:1 to 12:1, subject to risk, liquidity and market conditions. The $600 million 4% convertible senior notes mature in 2015.
- Operating cash flow was a use of $2.6 billion in Q2 and a source of $2.4 billion for the first six months. These cash-flow figures include large short-term financing and broker-dealer flows; they should not be read as operating earnings.
- Annualized return on average equity was 3.60% for Q2 and 13.39% for the first half. Common dividends declared were $0.65 per share for Q2 and $1.27 per share for the first half.
Material changes versus comparable periods
- Q2 net income improved by $339.0 million year over year, from a loss to profit. Management attributed the change chiefly to higher interest income and smaller unrealized swap losses; this was not solely a change in underlying spread income.
- Economic net interest income rose to $627.0 million from $363.4 million, and the spread increased to 2.45% from 2.16%. Average interest-earning assets grew to $94.7 billion from $62.0 billion, while asset yield declined to 4.04% from 4.16%; average cost of funds, including swaps, fell to 1.59% from 2.00%.
- Mortgage prepayment speeds slowed: portfolio CPR averaged 11% in Q2 2011 versus 32% in Q2 2010. Lower prepayments supported yields by reducing the pace of premium amortization.
- Net losses on interest rate swaps were $683.7 million in Q2, comprising $216.8 million realized and $466.9 million unrealized. The prior-year Q2 swap loss was $768.6 million. Separately, unrealized gains on available-for-sale securities drove $1.0 billion of Q2 other comprehensive income; accumulated other comprehensive income was $2.05 billion at quarter-end.
- Common shares outstanding increased from 631.6 million at year-end to 831.0 million at June 30, reflecting substantial equity issuance. Two January and February follow-on offerings generated approximately $2.94 billion net in total; direct-purchase and dividend-reinvestment issuances generated about $455.7 million in the first half.
Outlook, commentary, risks and unusual items
- No specific earnings, dividend or portfolio-growth guidance is provided. Management said it expected to continue financing activities primarily through repurchase agreements, while limiting asset growth to preserve unused borrowing capacity. It also said it continued to explore complementary strategies, without assurance they would be implemented.
- Interest-rate, yield-curve and mortgage-prepayment movements are principal risks. Higher rates can reduce modeled economic net interest income and portfolio value; faster prepayments can accelerate amortization of the portfolio’s substantial net premium. At June 30, net premium on investment securities was approximately $3.0 billion.
- Management’s parallel-rate-shock model estimated that a 25-basis-point increase would reduce economic net interest income by 1.74% and portfolio value by 0.43%; a 75-basis-point increase would reduce them by 6.87% and 1.58%, respectively. These are model estimates, not forecasts.
- Collateral value declines can trigger margin calls or forced asset sales. Annaly reported no repurchase-agreement margin calls it could not meet through June 30, but had no committed facilities requiring lenders to renew financing. Swap counterparty performance is also a risk.
- At quarter-end, interest-rate swap notional was $35.5 billion and the net fair-value liability was $1.04 billion. The filing’s presentation reclassified swap interest expense into realized swap gains or losses; comparisons should use the company’s economic-interest measures consistently.
- On July 11, the company agreed to sell 138 million common shares, settling July 15, for approximately $2.4 billion net proceeds. The filing also identifies potential dilution from future equity and convertible-security issuances. Ordinary-course legal matters were not expected by management to have a material effect; a contingent Merganser earn-out could be payable in 2012 depending on performance.
Important facts for investors to verify
- Reconcile GAAP net income with economic net interest income and swap gains or losses; assess how much reported earnings depended on noncash fair-value movements.
- Track repo financing availability, collateral haircuts, margin-call exposure, maturity profile and the company’s liquidity under adverse market conditions.
- Review portfolio premium, prepayment speeds, asset yields, funding costs and swap coverage as rates and the yield curve change.
- Confirm the July 2011 share issuance proceeds, updated share count and resulting per-share effects, including dilution and dividend coverage.
- Assess whether REIT qualification and required distributions remain supported by taxable income, and monitor the contingent earn-out and other disclosed commitments.