Orchid Island Capital, Inc. — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017. Amounts below are in U.S. dollars; financial statement amounts are generally shown in millions unless noted.
Business context
Orchid is an externally managed REIT investing primarily in Agency residential mortgage-backed securities (RMBS), financed largely through short-term repurchase agreements. Its objective is to earn income from asset yields and pay regular monthly distributions. The portfolio combines pass-through and structured Agency RMBS; interest-rate derivatives are used to manage funding risk.
Key financial metrics
| Metric | Q3 2017 / September 30, 2017 | Comparable period / prior balance |
|---|---|---|
| Interest income | $39.0 million | Q3 2016: $22.4 million |
| Interest expense | $12.6 million | Q3 2016: $4.0 million |
| Net interest income | $26.3 million | Q3 2016: $18.4 million |
| Net income | $15.2 million; $0.33 per diluted share | Q3 2016: $20.5 million; $0.85 per share |
| Net portfolio income | $18.1 million | Q3 2016: $22.8 million |
| Dividends declared | $0.42 per share for Q3 | $0.42 per share for Q3 2016 |
| Total assets | $4,144.4 million | December 31, 2016: $3,138.7 million |
| Agency RMBS at fair value | $3,930.3 million | December 31, 2016: $3,022.2 million |
| Repurchase agreements | $3,710.1 million; 1.37% net weighted-average borrowing rate | December 31, 2016: $2,793.7 million; 1.00% |
| Stockholders’ equity | $414.4 million | December 31, 2016: $332.8 million |
| Cash and cash equivalents | $161.7 million; restricted cash was $19.6 million | December 31, 2016: $73.5 million and $21.0 million, respectively |
| Cash flow, nine months | Operating cash flow: $43.6 million; investing: $(948.0) million; financing: $991.3 million | 2016: operating $14.1 million; investing $(286.3) million; financing $330.0 million |
For the nine months, net income was $8.0 million ($0.21 per share), versus $22.4 million ($0.99 per share) in 2016. Net interest income was $77.7 million versus $51.4 million. The nine-month economic net interest spread, a company-defined non-GAAP measure, was 2.42%, compared with 2.66% in 2016; Q3 2017 was 2.19%, compared with 2.57% in Q3 2016. These non-GAAP measures are not substitutes for GAAP results.
Material changes versus comparable periods
- Portfolio growth drove higher interest income, but borrowing costs rose: Q3 average RMBS increased to $3.83 billion from $2.36 billion, while average borrowings rose to $3.49 billion from $2.18 billion. Q3 GAAP cost of funds increased to 1.45% from 0.73%.
- Q3 net income declined year over year despite higher net interest income, reflecting lower portfolio income and losses on RMBS and derivatives. For the first nine months, RMBS recorded $35.6 million of unrealized losses; total derivative losses were $29.3 million.
- Equity increased following issuance of 12.3 million shares under the 2017 at-the-market offering program, generating $122.9 million in net proceeds. Common shares outstanding were 45.3 million at quarter-end, up from 33.0 million at year-end 2016.
- Average portfolio yield for Q3 was 4.07%, compared with 3.79% in Q3 2016. Higher asset yields and portfolio size were partly offset by higher funding costs and hedge-related losses.
- The effective duration measure reported for the RMBS portfolio was 2.603 at September 30, 2017, versus 4.579 at December 31, 2016; the company notes this measure excludes the effect of funding-cost hedges.
Outlook, risks and unusual items
- Management described Q3 as broadly consistent with the first half, while noting a change in market sentiment late in the quarter. It reported tight Agency MBS spreads and expected seasonal moderation in prepayments, but gave no specific earnings, spread, or dividend forecast.
- Management identified higher-than-expected inflation, further Federal Reserve tightening, rising rates and volatility, and wider mortgage spreads as risks to RMBS prices and performance. The filing’s modeled +100 basis-point rate scenario estimated a 14.47% decline in book value and a 1.53% decline in portfolio value; management cautioned that actual outcomes could differ materially.
- Liquidity and funding risks include reliance on short-term repos, renewal risk, potential higher collateral haircuts, and margin calls if collateral or derivatives decline in value. Repurchase agreements totaled $3.71 billion, had a 59-day weighted-average remaining maturity, and were secured by approximately $3.93 billion of RMBS and $12.0 million of cash. Management reported that all margin calls had been met and that funding facilities remained available on comparable terms through October 27, 2017.
- Management said it believed available liquidity and capital were sufficient for operations, debt repayments and dividends. Unrestricted cash was $161.7 million and unpledged securities were approximately $12.9 million at quarter-end.
- The company operates as a REIT and generally must distribute at least 90% of REIT taxable income annually to maintain qualification. A $0.14-per-share dividend declared October 11, 2017, payable November 10, was not reflected in September 30 financial statements.
- The company reported no known contingencies, no material pending legal proceedings, and no material changes to previously disclosed risk factors. Disclosure controls were concluded effective; no significant changes in internal control were reported.
Important facts for investors to verify
- How portfolio marks, spreads and hedge performance affected GAAP earnings and book value, including the significant Q2 and year-to-date valuation losses.
- Whether asset yields can continue to cover rising repo funding costs and derivative costs; review both GAAP and company-defined economic spread measures.
- Repo renewal terms, collateral haircuts, counterparty exposure and the company’s capacity to meet simultaneous margin calls.
- The sustainability of the monthly dividend relative to REIT taxable income, cash generation and future portfolio performance.
- The impact of further share issuance under the August 2017 equity distribution agreement on per-share results and equity.
- Key assumptions and uncertainty in the filing’s interest-rate sensitivity and prepayment estimates.