Ellington Financial LLC — Q3 2018 Form 10-Q
Business context and reporting period
Quarter ended September 30, 2018; comparisons include Q3 and the nine months ended September 30, 2018 versus 2017. Ellington is an externally managed specialty finance company investing in Agency and non-Agency mortgage assets, loans, CLOs, consumer credit, corporate securities, and derivatives. Amounts below are U.S. dollars; financial statement amounts are in millions unless stated otherwise.
Key financial metrics
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Investment income | $36.3 | $22.4 | $98.2 | $68.9 |
| Net investment income | $11.7 | $7.9 | $32.9 | $28.1 |
| Net increase in shareholders’ equity from operations | $6.7 | $6.2 | $48.9 | $26.5 |
| Per-share results from operations | $0.22 | $0.19 | $1.58 | $0.81 |
| Net interest margin, including swap costs | 3.26% | 3.28% | 3.17% | 3.77% |
At September 30, total assets were $3,714.6 million, total liabilities $3,097.9 million, and total equity $616.7 million. Cash and cash equivalents were $53.6 million, plus $0.4 million restricted cash. Common shareholders’ equity was $593.8 million; reported book value was $19.69 per share and diluted book value was $19.37.
Total borrowings were approximately $1,926.6 million: $1,636.0 million in reverse repos, $204.6 million in other secured borrowings, and $86.0 million in Senior Notes. Debt-to-equity was 3.12x including recourse and non-recourse borrowings, or 3.04x excluding U.S. Treasury securities. The Senior Notes bear 5.25% interest and mature in September 2022; the company reported compliance with their covenants.
Net cash used in operating activities was $421.1 million for the nine months, while financing activities provided $427.4 million; cash, cash equivalents, and restricted cash increased $6.4 million to $54.0 million. Operating cash flow reflects substantial investment purchases, sales, and settlement activity. Net asset-value-based total return was 1.10% for Q3 and 9.43% for the nine months, assuming reinvestment of distributions.
Material changes versus comparable periods
- Q3 investment income rose to $36.3 million from $22.4 million, but interest expense also increased to $15.7 million from $8.2 million, reflecting portfolio growth, higher funding costs, and higher rates. Q3 net investment income increased $3.8 million.
- Q3 shareholders’ operating results were $6.7 million, up from $6.2 million; investment gains and losses were less favorable, while derivative results improved. For the nine months, shareholders’ operating results increased to $48.9 million from $26.5 million, aided by stronger derivative results and higher net investment income.
- From December 31, 2017, total assets rose $721.2 million and total liabilities rose $725.5 million, while total equity declined $4.3 million. Long investments at fair value increased to $2,670.1 million from $2,071.7 million. Reverse repo borrowings increased $426.7 million.
- The long Credit portfolio grew to $1,378.9 million from $1,224.2 million at June 30, 2018, led by residential mortgage loans, European RMBS, non-Agency RMBS, commercial loans and consumer loans. Long Agency RMBS was $944.4 million, slightly below $948.5 million at June 30.
- Nine-month dividends were $1.23 per share versus $1.35 a year earlier. The company repurchased 1,186,058 shares during the nine months at an average $14.83 per share, costing $17.6 million; no shares were repurchased in Q3.
Outlook, risks, contingencies, and unusual items
- No quantified earnings or return guidance was provided. Management described an opportunistic, flexible investment strategy and expects Credit assets to remain the primary driver of risk and return.
- Management said it currently expects, subject to further analysis and unforeseen impediments, to convert from a publicly traded partnership to a REIT in the first half of 2019. Potential steps include selling or moving certain non-real-estate assets and restructuring part of the senior-note financing; no final decision had been made.
- The Federal Reserve raised its target range by 0.25% in September to 2.00%–2.25%. Management noted rising rates, a flattening yield curve, Federal Reserve balance-sheet runoff, and trade-policy uncertainty. Higher rates increased financing costs; Q3 weighted average cost of secured funds was 2.94%, versus 2.78% in Q2.
- Liquidity depends heavily on secured financing. Reverse repos had a 96-day weighted average remaining term; 17.5% matured within 30 days. Renewals, collateral haircuts, margin calls, adverse asset values, and prepayments may constrain liquidity. Management believed available capital resources would meet anticipated needs, but warned that inability to finance Agency RMBS could cause substantial short-term strain and asset sales.
- Fair values depend in part on estimates and unobservable inputs: Level 3 investments and derivative assets totaled $977.2 million at quarter-end. Changes in default, loss, recovery, prepayment, yield, or resolution assumptions could materially affect valuations and results.
- Credit exposure includes lower-rated and unrated holdings; the filing cautions that ratings may lag actual credit quality. Other key risks include interest-rate, prepayment, real-estate, foreign-currency, counterparty, and derivative risks.
- The company disclosed a January 2017 SEC subpoena concerning a loan originator and related loans, purchases, securitizations, and servicing. It had responded and intended to cooperate; no material proceeding was then considered pending, but further investigation or proceedings could adversely affect the company.
- A guarantee of a related mortgage originator’s third-party borrowing was capped at $40.0 million; $20.6 million was outstanding under the guaranteed arrangements, with a recorded fair value of zero. The filing also describes related-party loan, CLO, and financing transactions.
- The Board approved a Q3 dividend of $0.41 per share, payable December 17, 2018 to shareholders of record November 30, 2018. Quarterly net investment income per share was $0.39, below the declared dividend, making dividend coverage an important consideration.
Most important facts for investors to verify
- Whether repo funding remains available on acceptable terms, and how refinancing needs, collateral calls, and leverage evolve.
- Whether earnings and cash generation support the $0.41 quarterly dividend, particularly given net investment income per share of $0.39 in Q3.
- How assumptions and market inputs affect Level 3 valuations and the substantial credit portfolio.
- Whether the anticipated REIT conversion proceeds, and what asset sales, financing changes, or other costs it would require.
- Any developments in the SEC inquiry and the company’s related-party exposures, guarantees, and other contingent obligations.