Business context and reporting period
Annaly Capital Management, Inc. filed this unaudited Form 10-Q for the quarter ended September 30, 2017. The externally managed REIT invests in and finances residential and commercial real estate assets, using borrowing and hedging to earn investment spreads. Its groups cover Agency mortgage-backed securities, residential credit, commercial real estate, and middle-market lending. Comparisons below are with the three or nine months ended September 30, 2016, or with December 31, 2016 for balance-sheet figures, as applicable.
Key financial metrics
Amounts are in millions of dollars except per-share data, percentages, and ratios.
| Metric | Q3 2017 / Sep. 30, 2017 | Comparable period / prior date |
|---|---|---|
| Interest income | $622.6 | $558.7 in Q3 2016 |
| Net interest income | $353.6 | $384.5 in Q3 2016 |
| Net income attributable to Annaly | $367.5; $0.31 per common share | $731.2; $0.70 per share in Q3 2016 |
| Net income available to common stockholders | $337.2 | $708.4 in Q3 2016 |
| Core earnings excluding PAA (non-GAAP) | $353.5; $0.30 per share | $312.9; $0.29 per share in Q3 2016 |
| Net interest margin | 1.33%; 1.47% excluding PAA (non-GAAP) | 1.40%; 1.42% excluding PAA in Q3 2016 |
| Net interest spread | 0.97%; 1.15% excluding PAA (non-GAAP) | 1.13%; 1.15% excluding PAA in Q3 2016 |
| Total assets | $97,574 | $87,905 at Dec. 31, 2016 |
| Total equity | $14,155 | $12,576 at Dec. 31, 2016 |
| Repurchase agreements | $69,430 | $65,216 at Dec. 31, 2016 |
| Cash and cash equivalents | $867.8 | $1,539.7 at Dec. 31, 2016 |
| Common dividends declared | $0.30 per share in Q3; $0.90 for nine months | $0.30 per share in Q3; $0.90 for nine months in 2016 |
Cash flow, leverage, and liquidity
- For the first nine months of 2017, reported net cash from operating activities was $4,954.5 million, investing activities used $5,425.8 million, and financing activities used $200.7 million. Cash declined $671.9 million to $867.8 million. Operating cash flow includes substantial RCap repurchase and reverse-repurchase activity, so it should not be read as a simple measure of recurring operating cash generation.
- At September 30, repurchase agreements had a weighted-average borrowing rate of 1.38% before the MD&A’s separate hedged-cost presentation and an average remaining maturity of 65 days. Management reported a 1.88% weighted-average borrowing rate after giving effect to swaps used to hedge funding costs.
- Debt-to-equity leverage was 5.4:1 and economic leverage was 6.9:1; the company stated a general expectation to keep economic leverage below 10:1. The capital ratio was 12.3%.
- Management reported $9,654 million of unencumbered financial assets and liquid assets equal to 98.71% of encumbered and unencumbered financial assets. Most assets were pledged as collateral; repurchase-agreement haircuts averaged approximately 4%.
Material changes versus prior periods
- Q3 net income attributable to Annaly fell to $367.5 million from $731.2 million. Management attributed much of the decline to lower unrealized swap gains, unfavorable fair-value changes on investments measured through earnings, and the prior-year $72.6 million Hatteras bargain-purchase gain.
- For the first nine months, net income attributable to Annaly was $822.7 million versus a loss of $414.8 million in 2016. Higher net interest income and substantially less adverse swap valuation changes contributed to the improvement; trading-asset gains were lower.
- Nine-month net interest income increased to $1,058.1 million from $929.6 million, while interest expense rose to $689.6 million from $474.4 million. In Q3, higher expense more than offset increased interest income, reducing net interest income year over year.
- Assets increased approximately $9.7 billion from year-end 2016, primarily reflecting a $10.0 billion increase in Residential Investment Securities. Agency MBS fair value rose to $85.9 billion from $75.6 billion.
- Annaly raised approximately $816 million gross through Q3 common-stock offerings and $720 million gross through issuance of Series F preferred stock, and redeemed Series A preferred stock for $187.5 million. Common shares outstanding increased to 1.088 billion from 1.019 billion at year-end 2016.
Outlook, commentary, risks, and unusual items
- Management said it directed much of the capital raised into Agency MBS, which it viewed as attractive relative to credit after spreads widened earlier in the summer; Agency MBS performed strongly during Q3. It described its credit-investing approach as disciplined and said it avoided opportunities where credit fundamentals or protections were unattractive.
- Management expected interest-rate markets to remain largely range-bound, with gradual Federal Reserve tightening partly offset by low inflation and accommodative policies abroad. This is management commentary, not quantified company earnings guidance; the filing provides no clear earnings or dividend forecast.
- Market risks include interest rates, yield-curve and spread movements, mortgage prepayments, asset valuations, funding availability, collateral calls, and counterparty performance. Management’s sensitivity analysis estimated that a 75-basis-point rate increase would reduce portfolio value by 1.6% and projected economic net interest income by 3.0%; a 25-basis-point MBS spread widening would reduce portfolio value by 1.6%. The filing cautions actual results may differ materially.
- MSRs were a notable valuation exposure: fair value declined to $570.2 million from $652.2 million at year-end, including $19.2 million of Q3 decline attributed to valuation inputs or assumptions. MSRs are Level 3 assets dependent on unobservable assumptions.
- At quarter-end, $5.2 billion was payable for investments purchased, compared with $65.0 million at year-end 2016. The filing does not explain this balance in the provided text beyond presenting it in the balance sheet and cash-flow disclosures; investors should assess its settlement and funding implications.
- After quarter-end, Annaly issued 65.0 million common shares for $780.0 million gross and another 6.45 million shares for $77.4 million gross through the underwriters’ overallotment. These October offerings add capital but also increase share count.
- The company reported no material pending legal proceedings, no material contingencies, and no material changes to the risk factors in its latest Form 10-K. It reported effective disclosure controls and no material change in internal control over financial reporting during Q3.
Most important facts for investors to verify
- Reconcile GAAP earnings with non-GAAP core earnings, including the premium amortization adjustment, and track whether core earnings continue to cover the $0.30 quarterly common dividend.
- Monitor the widening gap between asset yields and funding costs, repo rates and maturities, swap costs, and the potential effects of further Federal Reserve tightening.
- Assess leverage, collateral availability, margin-call exposure, and the amount of short-dated repo funding; verify that reported liquidity remains adequate under stress.
- Review the assumptions supporting Agency MBS prepayments and Level 3 MSR valuations, along with portfolio sensitivity to rate and spread shocks.
- Track dilution and capital deployment from the Q3 and October equity offerings, and the material increase in investment-purchase payables at quarter-end.