ANNALY CAPITAL MANAGEMENT INC quarterly report, Q1 FY2018

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Annaly Capital Management, Inc. — Q1 2018 Form 10-Q

Business context and period. Annaly is an externally managed mortgage REIT investing in agency and non-agency residential mortgage assets, commercial real estate, mortgage servicing rights (MSRs), and middle-market corporate loans. This unaudited report covers the three months ended March 31, 2018; comparisons are with Q1 2017 unless otherwise noted.

Financial performance and position

  • Net interest income: $512.1 million, up 31.5% from $389.3 million. Interest income was $879.5 million and interest expense was $367.4 million. Management attributed the increase primarily to a larger average interest-earning asset base, partly offset by higher funding costs.
  • GAAP earnings: Net income attributable to Annaly was $1.328 billion, versus $440.5 million; diluted earnings per common share were $1.12 versus $0.41. Results included $977.3 million of unrealized interest-rate-swap gains. Net realized and unrealized gains overall were $844.7 million.
  • Underlying earnings measures: Non-GAAP core earnings excluding the premium amortization adjustment (PAA) were $385.3 million, or $0.30 per common share, versus $335.9 million, or $0.31 per share. Annualized core return on average equity excluding PAA was 10.70%, compared with 10.66%. These company-defined non-GAAP measures are not substitutes for GAAP results.
  • Margins and funding costs: GAAP net interest margin was 1.94%, compared with 1.47%; excluding PAA, it was 1.52%, compared with 1.55%. The non-GAAP net interest spread excluding PAA declined to 1.09% from 1.24%. Average cost of interest-bearing liabilities increased to 1.90% from 1.59%.
  • Comprehensive income and book value: Despite net income, comprehensive income attributable to common stockholders was a loss of $580.0 million, principally reflecting $1.874 billion of other comprehensive losses on available-for-sale securities. Accumulated other comprehensive loss widened to $3.000 billion from $1.126 billion at year-end. Common book value per share was $10.53, versus $11.23 reported for Q1 2017; total stockholders’ equity was $13.94 billion, down from $14.87 billion at December 31, 2017.
  • Cash flow: Operating activities provided $1.333 billion, versus $222.4 million used in Q1 2017; investing activities used $945.9 million; financing activities used $109.3 million. Cash and cash equivalents ended at $984.3 million, including pledged cash.
  • Assets, debt and liquidity: Total assets were $100.38 billion, down from $101.76 billion at year-end. Repurchase agreements were $78.02 billion; total indebtedness was $85.03 billion. Period-end debt-to-equity leverage was 6.1:1 and economic leverage was 6.5:1. Repo borrowings had a 1.83% weighted-average rate and 72-day weighted-average remaining maturity. Unencumbered financial assets were $7.29 billion; management reported liquid assets of $93.86 billion, or 98.59% of the stated financial-asset base.
  • Portfolio and shareholder distributions: Agency MBS were $88.58 billion and comprised 90.3% of the asset portfolio. Common dividends declared were $0.30 per share, unchanged from Q1 2017. The filing reports 1.160 billion common shares outstanding at quarter-end.

Material changes and management commentary

  • Rising rates and renewed market volatility challenged the quarter. Annaly said it reduced economic leverage, increased its hedge ratio, enhanced financing, and selectively diversified into credit assets, describing its stance as more defensive.
  • The 10-year Treasury rate rose to 2.74% from 2.41% at December 31, 2017; the 30-year mortgage current coupon rose to 3.46% from 3.00%. Annaly cited higher rates, Federal Reserve balance-sheet runoff, and market volatility as contributors to a modestly wider mortgage basis.
  • Net unrealized losses on available-for-sale investments increased substantially. The company said the decline reflected market conditions rather than asset credit deterioration; substantially all Agency MBS were rated or implied AAA, and management stated it intended and was able to hold them for recovery. A forced sale could nonetheless crystallize losses and reduce liquidity or borrowing capacity.
  • Interest-rate swap notional increased to $66.0 billion from $35.3 billion at year-end. The reported swap gain was a major driver of GAAP earnings and should be distinguished from recurring spread income.
  • Annaly redeemed $412.5 million of Series C and Series E preferred stock and issued Series G preferred stock for $411.3 million net proceeds. It also established a common-stock at-the-market program of up to $1.5 billion but reported no sales under it during the quarter.

Outlook, risks and contingencies

  • Acquisition: On May 2, 2018, Annaly agreed to acquire MTGE Investment Corp. for approximately $900 million of consideration to MTGE common shareholders, roughly half in Annaly shares and half in cash. Closing was expected in Q3 2018, subject to conditions including regulatory approvals. Annaly identified execution, integration, cost, dilution, and disruption risks, including limited experience with MTGE’s healthcare and senior-living portfolio. This was a subsequent event, not part of Q1 results.
  • Market and liquidity risks: Earnings, portfolio values, and collateral needs are sensitive to interest rates, yield-curve movements, mortgage spreads, prepayments, volatility, financing availability, and repo margin calls. Repo funding is short-term; about 48% of repo and other secured financing matured within 29 days. The filing’s instantaneous scenario analysis estimated that a 75-basis-point rate increase would raise modeled 12-month economic net interest income by 4.5% but reduce portfolio value by 0.9% (7.2% of NAV); actual outcomes could differ materially.
  • Credit and operational risks: Non-agency residential assets, CRTs, commercial loans and real estate, corporate debt, and MSRs expose the company to borrower, collateral, servicing, and counterparty risks. Management reported no impaired, nonaccrual, or defaulted residential or commercial loans and no loan-loss allowance at quarter-end; CRE risk ratings nevertheless included $67.4 million classified as substandard.
  • Other items: No material contingencies or material pending legal proceedings were reported. Management stated disclosure controls were effective and there were no material changes to internal control over financial reporting during the quarter. The company plans to adopt the expected-credit-loss standard on January 1, 2020 and was still assessing its impact.
  • Guidance: The filing provides no quantified earnings or dividend guidance. Management said it would continue disciplined credit-business growth and maintain a defensive, risk-managed portfolio approach.

Key facts investors should verify

  • How much of Q1’s GAAP earnings depended on unrealized swap gains, and how recurring core earnings and interest margins evolve as funding costs rise.
  • The effect of the $1.874 billion available-for-sale securities valuation decline on book value, collateral capacity, and potential asset sales.
  • Repo renewal terms, short-dated funding concentrations, unencumbered liquidity, and the ability to meet collateral calls under stressed markets.
  • Progress, financing, regulatory approvals, expected costs, and potential per-share effects of the MTGE acquisition.
  • Performance and credit migration in CRE and corporate lending, including the substandard CRE exposure, and the sensitivity of MSR valuations to rates and prepayments.