Annaly Capital Management, Inc. — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. Annaly is an externally managed mortgage REIT investing in residential and commercial real estate assets and middle-market corporate debt. The interim financial statements are unaudited.
Financial performance and position
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Interest income | $776.8 million | $537.4 million | $1,656.3 million | $1,125.2 million |
| Net interest income | $334.1 million | $315.1 million | $846.2 million | $704.4 million |
| Net income | $595.9 million | $14.5 million | $1,923.6 million | $454.9 million |
| Net income available to common shareholders | $564.5 million | $(8.8) million | $1,858.6 million | $408.2 million |
| GAAP diluted EPS | $0.49 | $(0.01) | $1.60 | $0.40 |
| Core earnings excluding PAA, per share (non-GAAP) | $0.30 | $0.30 | $0.61 | $0.61 |
- Q2 net interest margin was 1.53%, versus 1.23% a year earlier; excluding premium amortization adjustment (PAA), it was 1.56% versus 1.53%. Six-month margin was 1.74% versus 1.35% on a GAAP basis and 1.54% in both periods excluding PAA.
- GAAP earnings were strongly affected by fair-value movements: interest-rate swaps generated unrealized gains of $343.5 million in Q2 and $1.321 billion for the first half. Management attributed the gains primarily to rising forward rates. Core earnings exclude specified unrealized and other items and are non-GAAP.
- Other significant first-half items included $2.308 billion of other comprehensive losses, principally unrealized losses on available-for-sale securities, and $52.6 million of net losses on investment disposals. Management said the decline in Agency MBS values reflected market conditions, not asset credit quality, and did not consider the securities other-than-temporarily impaired.
- At June 30, total assets were $98.8 billion and total equity was $13.8 billion. Common book value per share was $10.35, compared with $11.19 at June 30, 2017. Net unrealized losses in accumulated other comprehensive income widened to $3.434 billion from $1.126 billion at year-end 2017.
- Cash and cash equivalents were $1.135 billion, including $1.043 billion pledged as collateral. Unencumbered financial assets totaled $7.374 billion; repurchase agreements and other financing arrangements encumbered $88.5 billion of financial assets.
- Repurchase agreements totaled $75.8 billion, with a 71-day weighted-average remaining maturity and a 1.91% weighted-average borrowing rate after swaps used to hedge funding costs. Total debt was $82.5 billion. Reported leverage was 6.0:1 and economic leverage 6.4:1; the company’s stated economic-leverage limit was 10:1.
- Six-month cash flows: $2.290 billion provided by operating activities, $1.074 billion provided by investing activities, and $2.935 billion used in financing activities. Cash increased $428.7 million to $1.135 billion. Cash-flow presentation includes substantial financing and investment turnover.
- Common dividends declared were $0.30 per share in Q2 and $0.60 for the first half, unchanged year over year. The July 31, 2018 common dividend payment was $0.30 per share.
Material changes versus comparable periods
- Q2 GAAP net income rose sharply from $14.5 million to $595.9 million, primarily because swap marks moved from a $177.6 million unrealized loss in Q2 2017 to a $343.5 million gain in Q2 2018. Core earnings excluding PAA per share were unchanged at $0.30.
- For the first half, net interest income increased $141.7 million, as higher asset income and average interest-earning assets more than offset higher borrowing costs. Core earnings excluding PAA increased to $768.1 million from $668.5 million, while per-share core earnings remained $0.61.
- Interest expense increased to $442.7 million in Q2 from $222.3 million, reflecting higher funding rates and average borrowings. The six-month average cost of interest-bearing liabilities, including swap interest, rose to 1.90% from 1.66%.
- Total assets declined to $98.8 billion from $101.8 billion at year-end 2017, mainly due to a $4.1 billion decrease in Residential Investment Securities. Corporate debt, residential mortgage loans, cash and reverse repurchase agreements increased.
- Residential Investment Securities’ fair value fell to $88.2 billion from $92.3 billion at year-end 2017. First-half securities disposals of $3.4 billion generated approximately $50 million of realized losses.
- Common shares outstanding increased to 1.164 billion from 1.160 billion at year-end 2017. Preferred capital was restructured: Annaly redeemed Series C and E preferred shares and issued $425 million gross of Series G preferred stock.
Outlook, commentary, risks and unusual items
- Management described a defensive portfolio posture, with leverage and hedges adjusted to maintain an agnostic rate view. It was cautiously optimistic on Agency MBS for the second half of 2018, increased selected credit exposure, and viewed broader credit markets as fully valued.
- Annaly agreed to acquire MTGE Investment Corp. for consideration of approximately $900 million, approximately half cash and half Annaly common stock, subject to closing conditions including regulatory approvals. Closing was expected in Q3 2018; the acquisition had not closed by the reporting date.
- Interest-rate sensitivity estimates, assuming no management actions, showed a +50-basis-point shock could increase projected 12-month economic net interest income 2.1% while reducing portfolio value by 0.6% and NAV by 4.2%. A -50-basis-point shock was estimated to reduce economic net interest income 8.0%. A +25-basis-point MBS spread shock was estimated to reduce NAV 11.2%. These are model estimates, not forecasts.
- Principal risks include rate, yield-curve, spread and prepayment changes; repo and collateral liquidity; counterparty performance; credit exposures in non-Agency, residential, commercial and corporate investments; and regulatory and REIT qualification requirements. Management warned that collateral calls or reduced financing availability could force asset sales at depressed prices.
- Commercial real estate and corporate loan portfolios had no reported impaired, nonaccrual or defaulted loans and no loan-loss allowance at June 30. However, internal ratings included $101.0 million of CRE loans rated Substandard; management said it expected contractual repayment.
- Subsequent events included an August 1 residential-loan securitization with $383.4 million face value and an amended management agreement. A separate CEO severance agreement provides for a potential $30 million payment upon specified separation events, subject to conditions.
- Management reported no pending material legal proceedings or material contingencies at June 30. It noted that actual results may differ materially from forward-looking statements; the filing provides no formal earnings guidance.
Important facts for investors to verify
- Reconcile GAAP earnings to core earnings and assess how swap valuations and other fair-value marks affect reported results versus recurring performance.
- Review the deterioration in book value and accumulated other comprehensive income, including the sensitivity of the highly leveraged portfolio to MBS spreads and rates.
- Assess repo rollover, collateral and liquidity exposure: $75.8 billion of repos, short weighted-average maturities, and the level and quality of unencumbered assets.
- Confirm MTGE acquisition closing, financing mix, integration progress, and potential dilution or accretion to earnings and book value.
- Review the amended management agreement and the conditions and potential cost associated with the CEO’s $30 million severance provision.