Invesco Mortgage Capital Inc. — Q3 2011 Form 10-Q
Reporting period: Three and nine months ended September 30, 2011. Comparative periods are the three and nine months ended September 30, 2010, except balance-sheet comparisons, which are against December 31, 2010. Dollar figures below are in U.S. dollars; financial statement amounts are converted from thousands to millions.
Business context
Invesco Mortgage Capital is an externally managed mortgage REIT investing in Agency and non-Agency residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and mortgage-related investments. It primarily funds securities with short-term repurchase agreements and uses interest-rate derivatives to manage exposure. Its stated objective is to generate risk-adjusted shareholder returns primarily through dividends.
Financial performance and position
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Interest income | $138.3m | $36.1m | $315.8m | $83.3m |
| Interest expense | $50.5m | $8.9m | $100.2m | $18.9m |
| Net interest income | $87.8m | $27.2m | $215.6m | $64.4m |
| Net income | $82.2m | $27.6m | $210.3m | $62.8m |
| Net income attributable to common shareholders | $81.1m | $26.2m | $206.3m | $59.0m |
| EPS, basic and diluted | $0.79 | $1.01 | $2.70 | $2.74 |
| Dividends declared per common share | $0.80 | $1.00 | $2.77 | $2.52 |
- Net interest margin was 2.39% in Q3 2011 versus 4.15% a year earlier, and 2.65% for the first nine months versus 4.07%. Management attributed the narrower margins to portfolio mix, lower asset yields, and hedging costs.
- Average portfolio yield fell to 4.15% from 6.06% in Q3 and to 4.21% from 5.75% for the nine-month period. Average hedged cost of funds was 1.76% and 1.56%, respectively, compared with 1.91% and 1.68% in the corresponding 2010 periods.
- At September 30, total assets were $15.25bn, including $14.34bn of mortgage-backed securities. Total liabilities were $13.32bn; total equity was $1.92bn. Repurchase-agreement borrowings were $12.18bn, up from $4.34bn at year-end 2010. Period-end debt-to-equity was 6.33x.
- Portfolio fair value comprised $10.16bn Agency RMBS, $2.67bn non-Agency RMBS, $1.37bn CMBS, and $143.4m MBS-CMO. Approximately 50.8% of equity was allocated to Agency RMBS, 29.9% to non-Agency RMBS, 13.6% to CMBS, and 5.7% to unconsolidated ventures.
- Cash was $56.9m and restricted cash was $254.6m. Operating cash flow for the nine months was $202.4m; investing cash outflow was $8.66bn and financing cash inflow was $8.45bn. Cash declined $6.6m from the start of the period. Management said available cash, operating flows, and borrowing capacity were expected to meet anticipated short-term needs.
- Book value per diluted share declined to $16.47 from $20.49 at December 31, 2010, primarily due to lower fair values of investments and interest-rate hedges recorded in other comprehensive income (OCI). Accumulated other comprehensive loss was $386.2m at quarter-end.
Material changes versus comparable periods
- Portfolio expansion drove substantial increases in interest income, net interest income, and net income. The company reported raising approximately $1.8bn in equity through five follow-on offerings since September 2010; nine-month 2011 stock issuance proceeds were approximately $1.30bn.
- Despite higher aggregate earnings, quarterly EPS fell to $0.79 from $1.01 and nine-month EPS to $2.70 from $2.74, reflecting the much larger weighted-average share count.
- Mortgage-backed securities increased from $5.58bn at December 2010 to $14.34bn at September 2011, while repurchase borrowings rose from $4.34bn to $12.18bn.
- Net unrealized losses on available-for-sale securities and qualifying derivatives were $416.7m for the nine months, compared with a $3.8m net unrealized gain in the prior-year period. Derivative liabilities rose to $388.9m from $37.9m at year-end.
- The company completed a 20.0m-share follow-on offering in August at $18.37 per share, netting approximately $362.2m, and issued 1.39m shares through its direct stock purchase plan for approximately $26.1m net.
Outlook, risks, and unusual items
- No specific earnings or portfolio guidance was provided. Management intended to continue regular quarterly distributions and stated that it believed short-term liquidity was adequate; longer-term funding needs depend on access to debt and equity markets. A $0.80-per-share dividend declared in September was paid October 27, 2011.
- Management highlighted refinancing and counterparty risk from short-term repo financing, margin calls if collateral values fall or haircuts rise, and potential difficulty obtaining financing during market stress. Repo collateral coverage was about 109% at quarter-end; the weighted-average repo rate was 0.60%. The company reported compliance with repo covenants.
- Interest-rate, spread, prepayment, extension, and credit risks may affect income, asset values, hedge effectiveness, and liquidity. The company had $6.925bn notional of cash-flow-hedging swaps, with a 2.29% weighted-average fixed rate; $128.2m of accumulated hedge losses was expected to be reclassified as higher interest expense over the next 12 months. It had posted approximately $20.9m cash and $446.7m Agency RMBS as swap collateral.
- The company sold protection under a non-Agency RMBS credit default swap. At September 30, notional was $120.6m, maximum potential future undiscounted payments were $90.5m, and collateral held by the counterparty was $18.5m. The filing reports no payments made under the contract.
- Unrealized losses on non-Agency RMBS and CMBS were attributed by management to non-credit market factors; no other-than-temporary impairment was recorded in 2011. Investors should note that these valuations and related impairment conclusions involve estimates and judgment.
- Key structural and regulatory exposures include REIT qualification, continued exemption from the Investment Company Act of 1940, and reliance on asset-composition tests. The filing added a risk factor concerning limits on operations and potential changes in interpretation of the 1940 Act exemptions. Management reported meeting REIT tests and believed the company was not required to register as an investment company at quarter-end.
- The company is externally managed; the agreement provides for a fee of 1.50% of defined shareholders’ equity and expense reimbursement without a dollar cap. Management fees were $7.9m in Q3 and $17.6m for the nine months. No legal proceedings were reported; disclosure controls were assessed as effective, with no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether repo financing remains available on acceptable terms, and the company’s capacity to meet collateral calls and derivative margin requirements.
- How portfolio growth, leverage, asset mix, and continued equity issuance affect per-share earnings, book value, and dividend coverage.
- Whether the $0.80 quarterly dividend is supported by taxable income and cash generation; reported EPS and dividends declared per share differ, and REIT distributions are based on taxable income rather than GAAP net income.
- The assumptions underlying fair values, impairment assessments, prepayment estimates, and the potential effect of further market movements on book value and OCI.
- Potential changes to REIT or Investment Company Act rules and the company’s ability to maintain the associated qualifications and exemptions.