Orchid Island Capital, Inc. — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2017. Unless stated otherwise, financial amounts below are in U.S. dollars; balance-sheet and income-statement amounts are in millions.
Business context
Orchid is an externally managed mortgage REIT investing primarily in agency residential mortgage-backed securities (RMBS). It funds much of its pass-through portfolio with short-term repurchase agreements and uses derivatives to manage some interest-rate exposure. Its stated objective is long-term risk-adjusted total return through capital appreciation and regular monthly distributions.
Financial performance and position
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Interest income | $34.6 | $19.2 | $66.9 | $39.7 |
| Interest expense | $8.8 | $3.3 | $15.5 | $6.6 |
| Net interest income | $25.8 | $15.9 | $51.4 | $33.1 |
| Net income (loss) | $(9.6) | $6.5 | $(7.2) | $1.9 |
| Basic and diluted EPS | $(0.26) | $0.29 | $(0.21) | $0.08 |
| Dividends declared per common share | $0.42 | $0.42 | $0.84 | $0.84 |
- Drivers and margins: Q2 average RMBS holdings rose to $3,499.9 million from $2,100.2 million a year earlier, and portfolio yield increased to 3.95% from 3.66%. Higher funding costs partly offset that growth: average GAAP funding cost rose to 1.11% from 0.67%; the economic cost, including designated period hedging effects, rose to 1.57% from 1.11%. Q2 GAAP net interest spread was 2.84% versus 2.99%; economic spread was 2.38% versus 2.55%. For the first half, GAAP and economic spreads were 3.01% and 2.56%, respectively, versus 3.14% and 2.72% in 2016. Economic measures are non-GAAP.
- Losses: Q2’s $9.6 million net loss included $17.1 million of unrealized RMBS losses and $19.4 million of derivative losses, partly offset by net interest income and $3.9 million of realized RMBS gains. For the first half, unrealized RMBS losses were $32.0 million, total RMBS losses were $29.5 million, and derivative losses were $23.9 million.
- Balance sheet at June 30: RMBS fair value was $3,737.8 million, total assets $3,982.9 million, repurchase agreements $3,278.5 million, total liabilities $3,564.7 million, and stockholders’ equity $418.2 million. At December 31, 2016, the corresponding figures were $3,022.2 million, $3,138.7 million, $2,793.7 million, $2,805.9 million, and $332.8 million. Repurchase debt was approximately 7.8 times period-end equity, excluding other liabilities.
- Cash flow and liquidity: First-half operating cash flow was $23.9 million, investing cash outflow $477.4 million, and financing cash inflow $578.7 million. Cash, cash equivalents and restricted cash increased $125.2 million to $219.7 million; unrestricted cash was $199.8 million. Unpledged securities were $286.9 million, including unsettled purchases due to be pledged after settlement.
- Funding: Repurchase agreements carried a 1.30% net weighted-average borrowing rate and had an 18-day weighted-average remaining maturity at quarter-end. Collateral haircuts averaged approximately 5.4%. Management said it had met all margin calls and maintained comparable repo terms through August 1, 2017, with maturities extending through October 30.
- Capital and distributions: The company issued 12.3 million shares under its 2017 at-the-market program through June 30, generating $122.9 million net proceeds. Shares outstanding increased to 45.3 million from 33.0 million at year-end. The company declared $0.84 per share for the first half; a further $0.14 per share dividend was declared July 12, payable August 10.
Material changes versus comparable periods
- Portfolio scale expanded substantially, supported by equity issuance and leverage: first-half average RMBS holdings increased 59% year over year, while average borrowings increased to $3,043.3 million from $1,981.5 million.
- Higher asset yields and a larger portfolio lifted net interest income, but higher short-term rates and increased borrowing balances raised funding costs. Economic net interest income increased to $44.6 million for the first half from $28.9 million.
- Results shifted from profits in 2016 to losses in 2017, principally reflecting weaker RMBS fair values and derivative results. First-half 2017 net loss was $7.2 million versus net income of $1.9 million in 2016.
- RMBS effective duration was 2.244 at June 30, 2017, compared with 4.579 at December 31, 2016; the filing notes this measure includes structured securities but excludes funding-cost hedges.
Outlook, risks and unusual items
- Management outlook: No numerical earnings or dividend guidance was provided. Management described softer inflation and economic data, a more dovish market view of future rate increases, a flatter Treasury curve, and mixed Q2 mortgage-market performance. It expected long-term rates to remain relatively low in the short to medium term and did not expect anticipated Federal Reserve balance-sheet reductions to cause material spread widening, while acknowledging uncertainty.
- Key exposures: Results and book value are sensitive to interest rates, RMBS spreads, mortgage prepayments, extension risk, short-term repo funding and counterparty performance. Repo agreements are short term and may not be renewed; falling collateral values or derivative losses can trigger margin calls. Hedging may not offset spread changes, and its effectiveness depends partly on prepayment assumptions.
- Rate sensitivity: The company’s model estimated that an immediate 100-basis-point rate rise would reduce investment portfolio value by 0.64% and equity by 5.74%; a 100-basis-point fall was estimated to reduce them by 1.36% and 12.20%, respectively. Management cautioned that these model-based static-portfolio estimates may differ materially from actual outcomes.
- Contingencies and regulation: Management reported no known contingencies at June 30 and no material pending legal proceedings. The captive insurance subsidiary had completed withdrawal from Federal Home Loan Bank membership and redeemed its shares; management did not expect this change to materially adversely affect core operations. The filing reported no material changes to previously disclosed risk factors and no off-balance-sheet arrangements.
- Other items: The company is a REIT and generally must distribute at least 90% of REIT taxable income to retain its status; GAAP losses do not establish whether distributions are covered by taxable income. Fair values for RMBS and certain derivatives rely on Level 2 inputs, including pricing sources and broker quotes. The management agreement with affiliate Bimini Advisors was renewed through February 20, 2018 and includes a termination fee if ended without cause.
Important facts for investors to verify
- Whether the monthly dividend is supported by taxable income and sustainable cash generation, rather than inferred from GAAP earnings alone.
- How repo funding costs, renewal terms, haircuts and margin requirements evolve as rates and collateral values change.
- The sensitivity of book value and earnings to RMBS spread movements, prepayments and hedging results; the filing’s rate scenarios are model estimates, not forecasts.
- The effect of the large equity issuance on per-share book value, earnings and distributions, and whether portfolio growth can maintain attractive net spreads.
- The quality and uncertainty of fair-value estimates, and the company’s exposures to counterparties and pledged collateral.