Annaly Capital Management, Inc. — FY 2012 Form 10-K
Reporting period: Year ended December 31, 2012; includes unaudited fourth-quarter results. Annaly is a mortgage REIT whose main business is financing a predominantly Agency mortgage-backed securities portfolio with repurchase agreements and distributing income to shareholders.
Financial performance and position
| Metric | FY 2012 | FY 2011 |
|---|---|---|
| Total interest income | $3.26 billion | $3.58 billion |
| GAAP net interest income | $2.59 billion | $3.10 billion |
| Economic net interest income, including swap interest expense | $1.70 billion | $2.22 billion |
| Economic net interest rate spread | 1.29% | 2.09% |
| Net income | $1.74 billion; $1.74 basic EPS | $344.5 million; $0.37 basic EPS |
| Net income available to common shareholders | $1.70 billion | $327.6 million |
| Return on average equity | 10.71% | 2.51% |
| Total assets at year-end | $133.45 billion | $109.63 billion |
| Stockholders’ equity at year-end | $15.92 billion | $15.76 billion |
| Debt-to-equity | 6.5:1 | 5.4:1 |
Fourth-quarter 2012 net income was $700.5 million, or $0.70 basic EPS; economic net interest income was $343.0 million and the economic spread was 0.95%. Cash and cash equivalents were $615.8 million at year-end. Operating cash flow was $7.64 billion, investing cash flow was negative $18.69 billion, and financing cash flow was $10.68 billion; operating cash flows include substantial securities-financing activity.
At December 31, 2012, repurchase agreements totaled $102.79 billion. Annaly reported a $9.9 billion excess capital cushion, approximately 5% average repo haircuts, and $109.2 billion of collateral pledged for repos and swaps. The net fair value liability on interest-rate swaps was $2.58 billion. The Agency MBS portfolio’s carrying value was $123.96 billion; its weighted-average yield was 2.75%. Approximately 93% of Investment Securities were fixed rate.
Changes versus the prior comparable period
- Average interest-earning assets grew to $116.36 billion from $96.68 billion, but their yield fell to 2.80% from 3.70%; economic spread declined to 1.29% from 2.09%. Management attributed weaker spread performance to the low-rate environment and higher prepayments.
- Economic net interest income declined by $518.7 million. Repo and swap-related economic interest expense rose as average interest-bearing liabilities increased, despite a lower average funding cost of 1.51% versus 1.61%.
- Annual net income rose sharply from 2011, primarily because unrealized swap losses were only $32.2 million in 2012 versus $1.82 billion in 2011. The comparison is therefore heavily affected by mark-to-market accounting, rather than an improvement in core spread income alone.
- Annaly repurchased approximately $492.5 million principal of its 4% convertible notes for $617.5 million, recording a $162.3 million extinguishment loss; it also issued $750 million of 5% convertible notes. Repo borrowings increased to $102.8 billion from $84.1 billion.
- Common dividends declared fell to $2.05 per share from $2.44. Quarterly declarations declined from $0.55 in the first half of 2012 to $0.50 in the third quarter and $0.45 in the fourth.
Outlook, risks and notable items
- No specific earnings, spread, or dividend guidance is provided. Management intends to continue financing primarily through repurchase agreements, maintain leverage below its general 12:1 ceiling, and preserve liquidity and unused borrowing capacity. It said swap pay rates were expected to continue declining as higher-rate swaps matured or were replaced.
- Management remained committed to Agency investments while indicating it may diversify into other real-estate-related assets. The filing describes authority to allocate up to 25% of stockholders’ equity to assets other than Agency MBS; the capital policy separately limits certain non-high-quality assets to 25% of total assets.
- Key risks include rising rates and faster repo repricing than asset repricing, mortgage prepayment speeds and premium amortization, market-value declines and margin calls, counterparty or repo-market disruption, and changes to Fannie Mae and Freddie Mac or the Agency guarantee framework. The Federal Reserve’s QE3 purchases could support security prices while also lowering yields and increasing refinancing activity.
- At year-end, the portfolio carried a $5.83 billion net premium, or 4.9% of current par, increasing sensitivity to faster prepayments. Average CPR was 19% in 2012 versus 17% in 2011. Management reported no other-than-temporary impairment on Agency MBS in 2012.
- After year-end, Annaly entered an agreement to acquire the remaining CreXus shares for $13.00 per share in cash, plus a prorated quarterly dividend, subject to conditions including a minimum tender threshold. The company said it planned to fund the transaction with cash on hand; completion was not assured.
- Annaly sold FIDAC Europe in December 2012 and liquidated FIDAC FSI in August 2012. Management said ordinary-course legal matters were not expected to have a material financial-statement effect. The filing states that Annaly remained compliant with REIT and Investment Company Act requirements at year-end.
Most important facts for investors to verify
- How much of reported earnings and EPS reflects swap valuation changes and the convertible-note extinguishment, versus recurring net interest income?
- Whether the narrowing spread, lower asset yields, prepayment speeds, and dividend reductions continue, and how they affect taxable income and future distributions.
- Repo renewal terms, collateral haircuts, available liquidity, margin-call capacity, and exposure to major financing and swap counterparties.
- The CreXus offer’s completion, cash funding needs, and expected effect on Annaly’s balance sheet and results.
- Whether Agency-market, regulatory, REIT-qualification, and interest-rate assumptions underlying management’s risk models remain valid.