ARMOUR Residential REIT, Inc. — FY 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. This is an annual filing, not a standalone fourth-quarter report; unaudited quarterly results are also summarized below. Financial amounts are in thousands of dollars except per-share data.
Business context
ARMOUR is an externally managed mortgage REIT investing primarily in residential mortgage-backed securities, financed largely through short-term repurchase agreements. It elected REIT tax treatment and seeks to earn returns from the spread between asset yields and funding costs, using derivatives to manage interest-rate risk. JAVELIN Mortgage Investment Corp. became a wholly owned subsidiary on April 6, 2016, expanding the portfolio into Non-Agency securities.
Financial performance and position
| Metric | FY 2016 / Dec. 31, 2016 | FY 2015 / Dec. 31, 2015 |
|---|---|---|
| Total interest income | $264.0 million | $365.3 million |
| Net interest income | $190.9 million | $306.0 million |
| Other loss | $198.9 million | $300.3 million |
| Net loss | $45.5 million | $31.2 million |
| Net loss per common share | $1.67 | $1.09 |
| Comprehensive loss | $7.3 million | $182.9 million |
| Operating cash flow | $(203.4) million | $238.3 million |
| Total assets | $8.0 billion | $13.1 billion |
| Repurchase borrowings | $6.8 billion | $11.6 billion |
| Stockholders’ equity | $1.1 billion | $1.2 billion |
The average portfolio yield was 2.71%, average cost of funds 1.32%, and interest-rate spread 1.39% in 2016, unchanged from 2015. Return on equity was negative 4.17%. Average MBS holdings declined 21.8% to $10.8 billion; the smaller portfolio was the principal driver of lower net interest income, while average yield and funding cost each rose 0.06 percentage points.
At year-end, reported debt-to-equity leverage was 6.24:1, or 8.92:1 including forward-purchased TBA securities on the stated basis. Repurchase agreements had a 22-day weighted-average maturity and 1.07% weighted-average contractual rate. Average financing haircuts were 7.45%, compared with 4.79% a year earlier. Liquidity was $517.8 million, comprising $271.8 million cash and $246.0 million unpledged Agency securities.
Agency securities were $6.5 billion at fair value; the year-end MBS portfolio also included $1.05 billion of Non-Agency securities and $33.6 million of Interest-Only securities. Non-Agency holdings were newly introduced in 2016 and included Level 3 fair-value estimates. Derivatives produced a net loss of $246.2 million for the year. Common dividends paid were $111.0 million, preferred dividends $15.6 million, and total dividends declared per common share were $3.02, down from $3.89. Approximately 81.55% of 2016 common dividends was classified as non-taxable return of capital.
Fourth-quarter snapshot: Net income was $94.1 million, or $2.46 per common share; net interest income was $42.6 million. The quarter included $203.3 million of unrealized derivative gains, partly offset by $113.6 million of realized derivative losses and a $37.1 million realized Agency-security sale loss.
Material changes and unusual items
- Portfolio and balance-sheet scale contracted substantially: Agency securities fell from $12.5 billion to $6.5 billion, while repurchase debt fell by $4.8 billion. Leverage declined from 9.44:1 to 6.24:1.
- The company acquired JAVELIN for $85.2 million in cash and recognized a $6.5 million bargain-purchase gain. JAVELIN contributed $13.4 million of interest income and $15.2 million of net income from acquisition through year-end.
- Derivative losses remained a major earnings item, although total other loss narrowed year over year. GAAP earnings can fluctuate substantially because derivative fair-value changes are recognized in earnings while unrealized changes in available-for-sale Agency securities generally flow through equity.
- ARMOUR recognized a $6.5 million other-than-temporary impairment on certain 15-year Agency securities, anticipating portfolio repositioning sales in January 2017.
- The common monthly dividend was reduced during 2016, from $0.33 early in the year to $0.22 for the remaining months; subsequent declarations were $0.19 per share.
- Management said it believed available liquidity and resources were sufficient for anticipated short-term requirements, but gave no quantitative earnings or dividend guidance.
Outlook, risks and contingencies
Management expects mortgage-market and government-sponsored-enterprise changes to create investment opportunities, but results remain sensitive to short-term funding rates, long-term rates, mortgage spreads, prepayments, collateral values, and access to repo financing. The filing’s year-end sensitivity analysis estimated that an immediate 100-basis-point rate increase would reduce projected net interest income 9.08% and projected shareholder equity, including hedges, 11.67%; a 25-basis-point widening in MBS spreads was estimated to reduce portfolio book value 10.41%. These are model-based estimates, not forecasts.
Key risks include margin calls and refinancing of short-term repo debt, rising funding costs, imperfect hedges, mortgage-spread volatility, faster prepayments, credit losses on Non-Agency securities, counterparty exposure, and potential changes to Fannie Mae and Freddie Mac or REIT/Investment Company Act rules. The company depends on external manager ACM; its fees are based on equity raised rather than investment performance, creating a disclosed conflict-of-interest risk.
Nine putative shareholder class actions relating to the JAVELIN transaction were disclosed. Defendants moved to dismiss; a hearing was scheduled for March 3, 2017. ARMOUR stated it could not estimate the outcome or potential exposure. Management and the auditor reported effective internal controls, and the independent auditor issued unqualified opinions on the financial statements and internal control.
Most important facts for investors to verify
- Whether the lower portfolio size, negative operating cash flow, and reduced common dividend are sustainable or indicate further contraction.
- Repo renewal terms, counterparty concentration, collateral haircuts, and liquidity available under stressed market conditions.
- Valuation assumptions and realized performance of the new Non-Agency portfolio, including Level 3 default, severity, delinquency, and discount-rate inputs.
- How derivative settlements and mark-to-market results affect reported earnings, book value, and cash collateral requirements.
- The outcome and potential cost of the JAVELIN-related litigation, and the effect of the acquisition on ongoing results.
- Dividend coverage using REIT taxable income and cash generation: 2016 estimated REIT taxable income was $36.1 million versus $126.6 million of total dividends paid.
- Terms and implications of the February 2017 management-agreement amendment, including its treatment of designated liquidation distributions and ordinary dividends.