Armour Residential REIT, Inc. — Q3 2011 Form 10-Q
Reporting period: Three and nine months ended September 30, 2011. Armour is an externally managed mortgage REIT investing primarily in Fannie Mae, Freddie Mac and Ginnie Mae residential mortgage-backed securities. It finances investments mainly through short-term repurchase agreements and uses derivatives to manage interest-rate risk.
Financial performance and position
| Metric | Q3 2011 / Sept. 30, 2011 | Comparable period / prior year-end |
|---|---|---|
| Net interest income | $36.2 million for Q3; $75.1 million for nine months | $3.5 million and $5.8 million, respectively, in 2010 |
| Net income (loss) | $(34.5) million for Q3; $(33.1) million for nine months | $(0.5) million and $(0.9) million, respectively, in 2010 |
| Basic and diluted loss per share | $(0.44) for Q3; $(0.63) for nine months | $(0.06) and $(0.20), respectively, in 2010 |
| Net interest margin | 2.18% for Q3 | 2.88% for Q3 2010 |
| Agency securities at fair value | $5.98 billion | $1.16 billion at Dec. 31, 2010 |
| Repurchase agreements | $5.22 billion; 0.27% weighted-average rate and 30-day weighted-average maturity | $0.97 billion at Dec. 31, 2010 |
| Total assets / stockholders’ equity | $6.38 billion / $574.7 million | $1.21 billion / $108.7 million at Dec. 31, 2010 |
| Book value per share | $6.78 | $6.61 at Dec. 31, 2010 |
| Cash / restricted cash | $250.5 million / $129.9 million | $35.3 million / $4.7 million at Dec. 31, 2010 |
Q3 results included $65.8 million of unrealized derivative losses and $8.4 million of realized derivative losses; for the nine months, derivative losses were $91.9 million unrealized and $16.4 million realized. The nine-month net loss also included a $6.4 million realized gain on securities sales. The company does not apply cash-flow hedge accounting, so derivative fair-value changes flow through GAAP earnings and may not coincide in timing with offsetting portfolio effects.
Net cash provided by operations was $73.2 million for the first nine months. Investing activities used $4.41 billion, principally for securities purchases; financing activities provided $4.56 billion. Cash increased by $215.1 million. The cash-flow measure reflects substantial noncash adjustments, including derivative mark-to-market losses.
Material changes versus comparable periods
- The portfolio and repo financing expanded sharply during 2011, funded by equity issuance and increased borrowing. The company reported issuing 56.4 million shares through offerings and other issuance activity, plus 11.9 million shares through its dividend reinvestment and stock purchase plan; total net proceeds from equity issuance were approximately $489.4 million.
- Interest income and net interest income increased with the larger portfolio, but the quarterly net interest margin declined to 2.18% from 2.88% a year earlier. Q3 asset yield was 3.11%; reported cost of funds including hedging was 0.93%, while the repo rate was 0.27%.
- Interest-rate swap notional rose to $2.8 billion from $155 million at year-end 2010; Eurodollar futures notional declined to $134 million from $214 million. Derivative liabilities were $94.4 million at September 30.
- Accumulated other comprehensive income rose to $63.3 million from a $4.2 million accumulated loss at year-end 2010, primarily reflecting unrealized gains on available-for-sale securities. GAAP accumulated deficit was $94.9 million.
- Dividends were $0.12 per share monthly through September, totaling $1.06 per share for the nine-month period. A subsequent October dividend of $0.11 per share was paid October 28.
Outlook, risks and notable items
- No specific earnings or net-interest-margin guidance is provided. Management said current equity, operating cash flow and borrowing capacity were expected to cover anticipated short-term liquidity needs; longer-term funding needs depend on access to debt and equity markets.
- Management described continued economic and interest-rate uncertainty, strong demand for agency securities, and low financing costs. It also noted that the timing of future Federal Reserve and Treasury actions and housing-finance reforms is uncertain.
- Primary risks include short-term repo funding against longer-duration assets, refinancing and counterparty risk, collateral haircuts and margin calls, interest-rate and yield-curve mismatch, mortgage prepayments, and the potential need to sell assets under unfavorable conditions. Repo borrowings were about 9.09 times stockholders’ equity; lenders may require additional collateral, and some agreements include leverage and termination provisions.
- The securities were purchased at a weighted-average amortized cost of 104.17% of par, with approximately $236.7 million of unamortized premium. Faster prepayments can accelerate premium amortization and reduce yields. The quarterly portfolio repayment rate was 12.4%.
- Management reported that the S&P downgrade of U.S. credit and the subsequent downgrades of Fannie Mae and Freddie Mac could affect agency-security values. The SEC was reviewing issues related to the Investment Company Act exemption used by mortgage REITs; a change could materially affect the business model.
- The company reported no pending, threatened or contemplated litigation and no material change in disclosure controls. An October 2011 at-the-market equity agreement authorized sales of up to 40 million shares; no shares had been sold under it as of September 30.
Important facts for investors to verify
- Whether underlying taxable income and cash generation support the dividend, given the substantial gap between REIT taxable income and GAAP earnings caused in part by unrealized derivative losses.
- How much of the derivative mark-to-market loss may reverse or persist, and whether the hedge portfolio offsets changes in asset value and funding costs over time.
- Repo renewal access, counterparty concentration, collateral haircuts, margin-call capacity and the effect of the approximately 9.09-to-1 leverage ratio.
- The sensitivity of net interest income and portfolio value to rates: management’s static model estimated that a 100-basis-point increase would raise projected net interest income 2.57% and reduce portfolio value 0.05%; a 100-basis-point decrease would reduce projected net interest income 20.43% and portfolio value 1.92%. These are model estimates, not forecasts.
- Potential dilution and per-share effects from further equity issuance, including the new 40-million-share distribution agreement and outstanding warrants for 32.5 million shares exercisable at $11 through 2013.