Annaly Capital Management, Inc. — Form 10-Q Summary
Reporting period: Quarter ended September 30, 2009; comparisons are with the quarter and nine months ended September 30, 2008, and balance-sheet comparisons are with December 31, 2008. Annaly is a REIT focused primarily on leveraged investment in agency mortgage-backed securities (MBS), financed mainly through repurchase agreements.
Financial performance and position
| Metric | Q3 2009 | Q3 2008 | Nine months 2009 | Nine months 2008 |
|---|---|---|---|---|
| Interest income | $744.5 million | $810.7 million | $2.171 billion | $2.375 billion |
| Interest expense | $307.8 million | $458.3 million | $1.009 billion | $1.438 billion |
| Net interest income | $436.7 million | $352.4 million | $1.162 billion | $937.0 million |
| Net income | $285.2 million | $302.1 million | $1.232 billion | $853.2 million |
| Net income available to common shareholders | $280.6 million | $296.8 million | $1.218 billion | $837.1 million |
| Basic / diluted EPS | $0.51 / $0.51 | $0.55 / $0.54 | $2.24 / $2.22 | $1.69 / $1.67 |
- Margins and returns: Q3 net interest spread was 2.65%, up from 2.08%; average asset yield was 4.89% versus 5.62%, while average cost of funds fell to 2.24% from 3.54%. Annualized return on average equity was 12.60% versus 16.73%; nine-month return was 19.56% versus 17.42%.
- Balance sheet at September 30: Total assets were $70.16 billion, including $66.84 billion of MBS and $1.72 billion of cash and cash equivalents. Repurchase agreements were $55.84 billion; total liabilities were $60.79 billion; stockholders’ equity was $9.31 billion. Debt-to-equity was 6.0:1, compared with 6.4:1 at year-end 2008. Management’s stated usual target range was 8:1 to 12:1.
- Cash flow: Cash increased $814.0 million over the first nine months to $1.72 billion. Net cash provided by operating activities was $8.57 billion and net cash used in investing activities was $8.58 billion; operating cash flows include substantial matched-repo activity. Dividends paid were $883.4 million.
- Distributions: Common dividends declared were $0.69 per share for Q3 and $1.79 per share for the first nine months. The $381.4 million Q3 common dividend was payable October 29, 2009.
Material changes versus comparable periods
- Q3 net income fell $16.9 million year over year, chiefly because the company recorded a $128.7 million unrealized loss on interest-rate swaps in earnings after discontinuing hedge accounting in 2008. Q3 net interest income nevertheless rose $84.3 million as lower funding costs more than offset lower asset yields.
- Nine-month net income increased $378.9 million year over year, reflecting a $224.9 million increase in net interest income and a $137.1 million unrealized swap gain, among other items.
- Assets grew to $70.16 billion from $57.60 billion at year-end 2008; repo borrowings rose to $55.84 billion from $46.67 billion. MBS fair value increased to $66.84 billion from $55.05 billion.
- Average mortgage prepayment speed rose to 21% CPR in Q3 from 11% a year earlier. The company’s MBS premium balance increased, making faster prepayments a potential drag on future interest income through accelerated premium amortization.
- Advisory and service fees increased to $14.6 million from $7.7 million for Q3. Assets under management at FIDAC and Merganser were reported at $11.3 billion net and $22.6 billion gross, up from $2.4 billion net and $10.5 billion gross a year earlier.
Outlook, risks and unusual items
- Outlook: The filing provides no specific earnings or dividend guidance. Management said it continues to explore complementary business strategies, but gave no assurance that any initiative will be implemented. It expected to maintain access to financing based on the agency guarantees and ratings of its securities, while acknowledging that market conditions remained difficult.
- Interest-rate and prepayment exposure: Management’s modeled parallel rate shocks showed projected net interest income down 1.32% and portfolio value down 0.35% for a 25-basis-point increase; a 75-basis-point increase implied declines of 4.50% and 1.28%, respectively. These are estimates and actual outcomes could differ materially.
- Funding and collateral risk: Repo financing is short-term and largely uncommitted. Declining collateral values or faster prepayments could trigger margin calls, reduce liquidity, or force asset sales. The company reported no repo margin calls it could not meet through September 30. Repo borrowings were collateralized by securities with an estimated fair value of $60.1 billion.
- Hedges and valuation: Interest-rate swaps had $20.64 billion notional value and a $788.1 million net fair-value liability at quarter-end. Changes in swap fair value are recognized in earnings following hedge-accounting de-designation; available-for-sale securities’ unrealized changes are generally recorded in other comprehensive income.
- Credit, market and counterparty risks: Core MBS and agency debentures were agency-backed and carried actual or implied AAA ratings, but their market values and funding availability remain exposed to market stress and lender or counterparty failure. The company warned that forced sales at depressed prices could reduce book value and liquidity.
- Contingencies and unusual exposures: A $16.9 million receivable tied to a Lehman Brothers International (Europe) account remained recorded using the last available statement from September 15, 2008. Recovery is uncertain; management had not determined a loss probable. Ordinary-course legal matters were not expected to have a material financial effect. Merganser’s former owners may receive an unquantified performance-based earn-out in 2012.
Important facts for investors to verify
- Whether reported net interest spread and funding costs remain sustainable as short-term financing reprices and asset yields and prepayments change.
- The sensitivity of book value and liquidity to MBS valuation changes, margin calls, lender availability, and the company’s high repo leverage.
- The economic and earnings effects of swap mark-to-market movements and the distinction between reported net income and changes recorded in other comprehensive income.
- How faster prepayments affect premium amortization, asset yields, and future dividend capacity.
- The collectability of the $16.9 million LBIE receivable and any subsequent developments concerning the Merganser earn-out or other contingencies.