ARMOUR Residential REIT, Inc. — Q3 2015 Form 10-Q
Business context and reporting period. Unaudited quarterly report for the three and nine months ended September 30, 2015. ARMOUR is an externally managed REIT investing primarily in Agency mortgage-backed securities, financed largely through short-term repurchase agreements and managed with interest-rate derivatives. Agency securities were 100% of its securities portfolio. Figures below are in U.S. dollars; financial statement amounts are generally in millions unless stated otherwise.
Financial performance and position
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Interest income, net of premium amortization | $85.6m | $107.5m | $276.9m | $344.5m |
| Net interest income | $71.2m | $92.3m | $234.4m | $295.3m |
| Total other gain (loss) | $(283.4)m | $(29.3)m | $(355.6)m | $(302.9)m |
| Net income (loss) | $(221.6)m | $54.1m | $(149.0)m | $(35.9)m |
| Net income (loss) available to common stockholders | $(225.5)m | $50.2m | $(160.7)m | $(47.6)m |
| Basic and diluted earnings (loss) per share | $(5.18) | $1.12 | $(3.68) | $(1.04) |
| Common dividends declared per share | $0.98 | $1.20 | $2.90 | $3.60 |
- Q3 net interest income fell 22.9% year over year. Management attributed the decline primarily to a smaller securities portfolio; for the nine-month comparison, the average portfolio was down 11.5% and the net interest rate spread narrowed 24 basis points, to 1.33%.
- Q3 net interest margin was 1.44%, versus 1.43% a year earlier; Q3 asset yield was 2.56% and cost of funds 1.12%. The quarter’s large GAAP loss was driven by $266.1m of unrealized derivative losses and $17.4m of realized derivative losses. Derivative fair-value changes run through earnings, while unrealized changes in available-for-sale securities generally run through other comprehensive income.
- Available-for-sale securities recorded a $137.3m unrealized gain in Q3, but only $5.2m for the first nine months. Comprehensive loss was $84.3m for Q3 and $145.3m for the nine months.
- Operating cash flow was $180.5m for the first nine months, versus $205.2m in 2014. Cash declined $218.1m to $276.5m; financing cash flow was a use of $1.462bn. Cash dividends paid included $127.7m on common stock and $11.7m on preferred stock.
- At September 30, total assets were $14.396bn, including $13.637bn of Agency securities; total liabilities were $12.977bn and stockholders’ equity $1.419bn. At December 31, 2014, assets were $16.286bn and equity $1.749bn.
- Repurchase-agreement borrowings were $12.596bn, down from $13.882bn at year-end 2014. Their weighted-average contractual rate was 0.48%, versus 0.38%; weighted-average maturity was 46 days. Leverage was 8.87:1, or 10.04:1 including TBA securities.
- Reported liquidity was $682.9m: $276.5m of cash and $406.4m of unpledged Agency securities. Securities had a 3.44% weighted-average coupon. No other-than-temporary impairment was recognized.
Material changes and notable items
- Compared with Q3 2014, the company moved from net income of $54.1m to a $221.6m net loss, principally reflecting the reversal from derivative gains to substantial derivative mark-to-market losses and the smaller portfolio.
- Year-to-date net loss widened from $35.9m to $149.0m; realized gains from security sales were $1.6m versus $68.6m in the prior-year period.
- Stockholders’ equity declined to $1.419bn from $1.749bn at year-end. Management said that an unusual decline in swap rates relative to Treasury rates during the quarter negatively affected book value; the company had no asset or contract specifically designed to offset mortgage-spread movements.
- A one-for-eight reverse stock split took effect July 31, 2015; reported per-share and share-count comparisons reflect the split. The company repurchased 2.153m post-split shares for $46.0m during the first nine months. Common dividends were reduced year over year.
- After quarter-end, ARMOUR repurchased another 2.191m shares for $46.0m during October and reported 5.041m shares of remaining repurchase authorization as of November 5. It paid a $0.33 common dividend in October and declared $0.33 monthly common dividends for November and December; preferred dividends were also declared.
Outlook, risks and contingencies
- No specific earnings or financial guidance was provided. Management said it believed operating cash flow and available borrowing arrangements would meet anticipated short-term liquidity needs, including financing, expenses and distributions; future financing through equity, debt or long-term credit facilities depends on market conditions and is not assured.
- Management expected to remain primarily invested in Agency securities and cited potential investment opportunities as the mortgage market and GSE roles evolve. It also noted Federal Reserve discussions about potential rate increases and the sensitivity of funding costs to short-term rates.
- Principal risks include interest-rate and spread volatility, prepayment speeds and premium amortization, leverage and short-term repo funding, collateral margin calls, counterparty and liquidity risk, and possible GSE reform or changes to government support. Repo agreements may require additional collateral or allow termination; some contain a 12-times-equity leverage restriction.
- Derivative hedges may not offset asset-price changes effectively. ARMOUR does not use cash-flow hedge accounting, so derivative fair-value changes can create substantial GAAP earnings volatility even when hedges are intended to manage economic exposure. Modelled sensitivity estimated that a parallel 100-basis-point rate increase would reduce projected net interest income 10.21%; the filing cautions that estimates rely on assumptions and actual outcomes may differ materially.
- The external management fee is based on gross equity raised, not asset performance, and may not decline with earnings. Management reported no pending, threatened or contemplated litigation and no material changes to risk factors beyond those previously disclosed. Disclosure controls were concluded effective as of quarter-end.
Important facts for investors to verify
- Whether derivative mark-to-market losses, collateral needs and book-value sensitivity persist or reverse as interest rates and mortgage spreads change.
- Current repo borrowing terms, counterparty concentration, haircuts, margin calls and the availability of unpledged collateral; the reported liquidity figure includes securities, not only cash.
- Whether the narrowed nine-month spread and smaller portfolio continue to constrain net interest income, and how prepayments affect premium amortization and asset yield.
- Common-dividend sustainability relative to REIT taxable income and cash needs. Estimated nine-month REIT taxable income was $110.0m, compared with $139.4m of total dividends paid; annual REIT distribution requirements are determined on an annual basis.
- The effects of ongoing repurchases and the reverse split on share count, book value per share and future capital flexibility, as well as the terms and incentives under the external management agreement.