Business Context and Reporting Period
National Rural Utilities Cooperative Finance Corporation (CFC) filed this unaudited Form 10-Q for the quarter ended November 30, 2016, covering the three and six months ended on that date. CFC is a member-owned, tax-exempt cooperative lender serving rural electric utilities; it also provides guarantees and letters of credit. The consolidated results include RTFC and NCSC. CFC’s objective is to provide cost-based financing while maintaining financial strength, rather than maximizing profit.
Financial Performance and Position
Amounts below are in millions of dollars unless otherwise noted. GAAP results are materially affected by unrealized changes in derivative fair values; adjusted measures are non-GAAP and exclude derivative forward-value gains or losses while including periodic derivative cash settlements.
| Metric | Three months ended Nov. 30, 2016 | Six months ended Nov. 30, 2016 | Prior-year comparable period |
|---|---|---|---|
| Interest income | $257.2 | $514.0 | $256.3 / $502.4 |
| Net interest income | $73.5 | $149.3 | $89.2 / $169.6 |
| Adjusted net interest income | $51.9 | $104.3 | $66.6 / $126.9 |
| GAAP net income (loss) | $395.3 | $263.0 | $(24.5) / $18.6 |
| Adjusted net income | $33.1 | $65.7 | $54.1 / $89.1 |
| GAAP TIER / adjusted TIER | 3.15 / 1.16 | 1.72 / 1.16 | 0.85 / 1.29; 1.06 / 1.24 |
Net interest yield was 1.21% for the quarter and 1.23% for the six-month period, compared with 1.56% and 1.50%. Adjusted net interest yield was 0.86% in both 2016 periods, versus 1.17% and 1.12%. The decline reflected lower yields on earning assets and higher funding costs. CFC recorded derivative gains of $340.7 million for the quarter and $152.4 million for six months, primarily from rising medium- and longer-term rates; the corresponding prior-year periods recorded losses of $101.2 million and $113.2 million. The gains largely explain the sharp increase in reported GAAP income and are not equivalent to recurring operating earnings.
- Balance sheet at Nov. 30: total assets $25.15 billion, loans to members net of allowance $23.82 billion, total debt $23.47 billion and equity $1.05 billion. Loans increased 3% and debt 4% from May 31, 2016; equity rose 28%.
- Debt and leverage: short-term borrowings were $3.66 billion, up from $2.94 billion; long-term debt was $17.62 billion. GAAP debt-to-equity was 23.04-to-1, down from 28.69-to-1, while adjusted debt-to-equity rose to 6.02-to-1 from 5.82-to-1, slightly above management’s stated 6.00 target.
- Liquidity: cash, cash equivalents and time deposits were $830 million. Available liquidity reserves were reported at $7.01 billion, including $3.16 billion available under bank revolvers and $500 million under committed Federal Financing Bank facilities. A further $375 million facility closed December 1, after quarter-end, increasing available access under the Guaranteed Underwriter Program to $875 million.
- Cash flow for six months: operating cash flow was $78.9 million versus $96.0 million; investing cash outflow was $907.5 million versus $1.07 billion; financing cash inflow was $814.1 million versus $967.8 million. Cash and cash equivalents ended at $190.1 million. Investing activity included $3.93 billion of loan advances and $3.30 billion of principal collections.
- Credit quality: allowance for loan losses was $33.9 million, or 0.14% of loans. No loans were past due or nonperforming at Nov. 30; all $13.4 million of TDR loans were performing. Criticized loans were 0.2% of the portfolio.
Material Changes Versus Prior Period
- GAAP net income improved sharply year over year because derivative fair-value movements reversed from losses to gains. Adjusted net income, by contrast, declined 39% for the quarter and 26% for six months.
- Adjusted net interest income fell 22% for the quarter and 18% for six months, despite average interest-earning asset growth of 6% and 7%, respectively. Adjusted funding cost increased as CFC used more higher-cost, longer-term debt.
- Loans outstanding increased by $688 million from May 31, largely due to distribution-system lending, member refinancing and capital investment advances. Total debt rose by $867 million, with much of the increase in commercial paper.
- Equity increased by $229 million, primarily from six-month net income, partly offset by $42 million of patronage capital returned to members.
- CFC completed the sale of Caribbean Asset Holdings (CAH) on July 1, 2016. It received $109 million net at closing, with $16 million placed in escrow for potential indemnification claims; no foreclosed assets remained on the Nov. 30 balance sheet.
Outlook, Risks, Contingencies and Unusual Items
- Management expected new long-term loan advances to exceed scheduled repayments over the next 12 months and projected relatively flat net interest income and adjusted net interest income as loan growth is offset by lower yields.
- Long-term debt maturities over the next 12 months totaled $2.19 billion, including $1.44 billion in fiscal 2017’s fourth quarter. Management cited available cash, loan repayments, committed facilities and capital-market access as sources to meet maturities and lending needs. It expected to maintain adjusted debt-to-equity at approximately 6.00-to-1.
- Management expected continued rollover of member short-term debt and dealer commercial paper, and intended to keep dealer commercial paper below $1.25 billion. These expectations depend on member investment behavior and continued market access.
- Off-balance-sheet exposures included $888 million of guarantees, with a recorded guarantee liability of $16 million; up to a further $84 million of letters of credit could be issued under existing master facilities. Unadvanced loan commitments totaled $12.74 billion, but management expected most to expire without being fully drawn. $2.62 billion of line commitments were unconditional.
- Key risks include interest-rate and derivative valuation volatility, credit quality, refinancing and rollover risk, access to external funding, counterparty performance, and conditions in the rural electric industry. Derivatives had a net fair-value liability of $317.6 million; specified rating-trigger terminations could require a net payment of $233.2 million. No counterparty had breached a rating trigger at Nov. 30.
- Management reported compliance with bank-facility and senior-debt covenants and stable investment-grade ratings. It stated that there were no material changes to the risk factors in the 2016 Form 10-K. Disclosure controls were assessed as effective.
- In January 2017, after the reporting date, RTFC and the Virgin Islands Bureau of Internal Revenue agreed to cancel a tax deficiency notice and dismiss the related action with prejudice; no further proceedings were anticipated. Management said ordinary-course legal proceedings were not expected to have a material adverse effect and had recorded no legal reserve.
Important Facts for Investors to Verify
- Reconcile reported GAAP earnings to adjusted earnings and assess the effect of derivative mark-to-market movements versus cash settlements.
- Review the sustainability of net interest yield and adjusted TIER, particularly against management’s 1.10 minimum adjusted TIER goal.
- Confirm liquidity availability, including conditions on Farmer Mac access, bank-facility covenants, the post-quarter $375 million facility and upcoming debt maturities.
- Assess leverage relative to management’s 6.00-to-1 adjusted debt-to-equity target and the funding required for expected loan growth.
- Evaluate guarantee and unconditional commitment exposures, collateral coverage, credit quality trends and the CAH escrow and indemnification obligations.