C3.ai, Inc. (AI) Q2 2015 Earnings Report, Transcript and Summary

Good morning. I’d like to welcome everyone to the Arlington Asset Second Quarter’s 2015 Earnings Call. Please be aware that each of your lines are in a listen-only mode. After the company’s remarks, we will open the floor for questions. [Operator Instructions] I would now like to turn the conference over to Richard Konzmann. Mr. Konzmann, you may now begin.

Thank you very much and good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this morning’s call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations, and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risk and uncertainty that might cause actual results to differ materially from stated expectations or current circumstances. These forward-looking statements are based on management’s beliefs, assumptions and expectations which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company’s Annual Report on Form 10-K for the year ended December 31, 2014, and other documents filed by the company with the SEC from time-to-time, which are available from the company and from the SEC and you should read and understand these risks when evaluating any forward-looking statement. I would now like to turn the call over to Rock Tonkel for his remarks.

Thank you, Rich. Good morning and welcome to the second quarter 2015 earnings call for Arlington Asset. I’m Rock Tonkel, Chief Executive Officer. Also joining me today on the call are Eric Billings, our Executive Chairman; and Brian Bowers, our Chief Investment Officer. We reported core operating income per share diluted of a $1.76 for the second quarter, an increase from a $1.50 per diluted share in the first quarter of 2015 and a $1.15 per diluted share in the second quarter of 2014. Core operating income for the quarter benefited from increased net interest income from the company’s agency MBS portfolio and cash gains from the sale of private label MBS. Excluding the gains on the private label MBS, core operating income for the second quarter was a $1.32 per diluted share and increase from a $1.27 per share in the first quarter 2015 and a $1.18 in the second quarter of 2014. During the second quarter, we witnessed continued interest rate volatility as uncertainty persisted over global growth. The outlook for timing and magnitude of rate increases by the Federal Reserve and European financial conditions. We adopted a more balance hedge approach and posture in the agency MBS portfolio during the quarter, yet wider spreads on the agency MBS in the second quarter contributed to net declines in the value of our agency MBS compared to gains in the company’s hedge position. In addition with the rise in interest rates during the quarter, pay-up premiums on our prepayment protected agency MBS portfolio declined which also contributed to the net decrease in our hedge agency MBS portfolio. Against this backdrop, the company recorded a net loss on its hedged agency MBS portfolio of $31.4 million during the second quarter comprised of $61.8 million of net investment losses on our agency portfolio partially offset by net investment gains on the hedge portfolio of $30.4 million which was a significant driver to the reduction in our book value per share of $23.71 at quarter end. During the quarter, the company received $89 million of proceeds from the sale of private label MBS for a GAAP realized gain of $13.1 million. Net sale proceeds from these private label MBS after deducting associated repurchase financing was $66.8 million. The change in value of the company’s private label MBS portfolio during the second quarter inclusive of the sale price for sold private label MBS contributed to an $0.18 per share decline in book value during the quarter. The company has seen small pockets of new investment opportunities in private label MBS, having invested $2.9 million of capital into new private label MBS during the quarter. We remained cautiously optimistic that we could see additional opportunities in private label MBS, although the volume of new investments at our targeted investment returns is uncertain. Although spread widening resulted in downward pressure on book value per share, it created more attractive levered returns on new agency investments made during the quarter. At quarter end, the company had approximately 77% of investable capital directed to its agency MBS portfolio and 23% allocated to its private label MBS portfolio. Compared to an allocation of investable capital of 68% to agency MBS and 32% to private label MBS at the end of the first quarter. As our private label MBS have reached their expected returns, the performance of our private label MBS has generally plateaued. During the quarter, we selectively sold private label MBS and reallocated the capital into higher return investments and we expect to continue that reallocation process going forward. As of today, a new investment in a 4% coupon 30-year spec pool agency MBS offers an asset yield of approximately 3.15% and a blended hedge funding cost of approximately 1.9% resulting in an expected return in the low to mid teens on a hedged and levered basis. As of quarter end, the company continues to invest entirely in 30-year fixed rate securities within its agency MBS portfolio, with the modest migration to lower coupon fixed rate agency MBS as our weighted average coupon declined slightly from 4.03% as of March 31 to 3.98% as of June 30, 2015. 48% of the portfolio was invested in specified pools of low loan balance loans approximately 30% in specified pools of loans issued under the HARP program, while the remainder includes specified pools of loans with low FICO scores or with other characteristics selected for prepayment protection. Pay-up premiums on these securities declined this quarter in response to the increase in interest rate and were approximately one-half of a point at quarter end compared to approximately three-quarter of a point at the prior quarter end. Mortgage prepayments fees were elevated during the quarter in response to recent periods of low interest rates and appreciating housing prices among other factors. With a 100% focus on prepayment protected agency MBS, our portfolio experienced a three months CPR of 12.34% as of June 30, 2015 versus CPR of 21.87% on the Fannie Mae 4% coupon universe. We have observed CPR declines over the last two months and our expectation is that at current interest rate levels over time CPRs will move back towards historical norms in the single digit. The company continues to maintain a hedge structure comprised of Eurodollar futures and long-term 10-year interest rate swap futures to help mitigate the impact of rising interest rates on our agency MBS portfolio. Our Eurodollar futures generally run consecutively through June 2019 with additional lower amounts of Eurodollar futures running consecutively from June 2019 through June 2020 for a total weighted average quarterly notional amount of $2.427 billion with a contractual average rate of 2.69%. And a mark-to-market rate of 1.74% at June 30, 2015. Complimenting this hedge, we had a 10-year interest rate swap future with a notional amount of $1.075 billion as of June 30, 2015 with a weighted average contract rate of 2.77% and a mark-to-market average rate of 2.47%. As of June 30, the total combined hedge position had a weighted average contract rate of 2.72% and a mark-to-market rate of 1.97%. With U.S. Federal Reserve policymakers continuing to focus commentary on a 2015 lift-off in interest rates, we continue to maintain the substantial hedge against our outstanding agency MBS repurchase financing of approximately 97% as of June 30, 2015. During the quarter, we increased our long-term hedges to 31% of our total hedge portfolio as of quarter end compared to approximately 27% as of the prior quarter end. In recent quarters, as the company’s allocation of capital to agency MBS has grown the higher net interest income associated with that portfolio growth has contributed to an increase in the company’s core operating income per share. However, the economic costs of the company’s hedge instruments have generally increased proportionately with the growth in the agency MBS portfolio. Economic costs of the company’s hedge instruments are ultimately reflected through GAAP net income and changes in book value per share rather than core operating income per share. Our private label MBS portfolio at June 30, 2015 had a fair value of 76.5% of face value. Total market value of $152.2 million and outstanding repo of $39.4 million. Net unrealized gains within accumulated other comprehensive income related to the private label securities was $19.3 million as of June 30, 2015. The assumptions used to value that portfolio at that time included on a weighted average basis a constant default rate of 2.9%, loss severity on liquidated loans of 42.8%, a constant prepayment rate of 11.1% and a discount rate of 5.6%. The company continues to benefit from the flexibility of its tax status as a C-Corporation due to its net operating loss and capital loss carry forwards. Also shareholders generally continue to benefit from our tax status since distributions to shareholders of current or accumulated earnings and profits are qualified dividends eligible for the lower federal capital gains rates whereas similar distributions to shareholders by a REIT are non-qualified dividends subject to higher federal ordinary income tax rate. As of June 30, 2015, the differed tax asset remained relatively unchanged from the prior quarter at a $113.1 million or $4.92 per share, comprised mostly of net operating loss carry forwards and net capital loss carry forwards. During the quarter, the company recorded modest increases to the valuation allowance against its differed tax asset. Our balance sheet is flexible and composed of liquid securities. Our complimentary MBS portfolio includes private label MBS that comprises approximately 23% of our capital which offer significant untapped liquidity and our benefit – our tax benefits provide additional flexibility to our business. With the expectation that the federal rate short-term interest rates later this year, we continue to maintain a substantial hedge position to protect our book value from rising interest rates. Consistent with our long-term view, as the economy and markets have gradually normalized, so have investment returns. We entered the non-agency opportunity, generated outsize returns from that portfolio for several years and subsequently have been reallocating capital away from that mature investment for higher expected agency MBS return. Likewise, as the interest rate curve is flattened overtime and earlier investments in agency MBS made at wider spreads run-off, more recent investments are generating lower although still attractive returns in the low teens net at amortization hedge and financing costs. Whereas the asset returns associated with the company’s historical returns we’re in the high teens. Looking forward, while the expected Fed tightening will likely lead the future higher financing costs and compressed spread income overtime. The company believes that the attractive or hedged returns from its agency MBS portfolio coupled with the opportunity to redeploy its remaining private label MBS portfolio in the higher returning investments, will allow the company to continue to offer shareholders and attractive return on their investment overtime. Operator, I would now like to open the call for questions.

Thank you. At this time we will open the floor for questions. [Operator Instructions] Our first question comes from Trevor Cranston with JMP Securities.

Hey, thanks. Good morning.

Good morning, Trevor.

Good morning. First question, as the capital is transitioned over the last several quarters more and more to agency MBS, there is obviously been earnings accretion. But there has also been an increase in the book value volatility you guys have experienced as rates move around. Can you talk about kind of how you think about that balance of increased earnings potential versus higher book value volatility, whether or not you guys see any value in adding some maybe shorter duration assets to book that have lower return but maybe a less expected price risk in the future?

Thanks for the question Trevor. A couple of thoughts, one is that to the extent that rates are - the marks, the volatility in book value is due to lower rates than obviously that’s a benefit that we would get going forward to earnings. And so that volatility can create a better earning and opportunity over time in certain cases. On the other hand that may not be the case always, rising rate environment which is why we maintain the magnitude of the hedge that we do, so that we have the flexibility in rising rate environment to potentially reset the portfolio. We, as we’ve talked about before, we examined alternatives within the agency spectrum as well as within the non-agency spectrum at all times. We continue to identify a subset of non-agency opportunities that we think is interesting, the question there is what volume we can derive in our targeted returns, and we’ve not been able to generate substantial volume in that newer re-remic class of opportunities that we spoke about in the script. Until we can determine that I think our primary focus will continue to be here in the hedged agency side and we’ve sought to mitigate some of that book value volatility by balancing the hedge – balancing the net duration on the hedge more, and I think we achieved a more balanced position in the quarter but then with the spread widening we’ve had one still had experienced that some volatility in the book value per share. I think that’s how we look at it.

Okay, that’s helpful. And then second, to kind of follow-up on your comments about the expected decline in net interest income as the Fed begins to raise rates at some point. And also returns on investment opportunities normalizing at a little bit lower level than where they were in the past. Can you make any comments on how you’re thinking about the dividend policy heading into 2016 with that backdrop? Thank you.

Sure. So the dividend is a variable dividend, it’s evaluated every quarter. What we’re trying to convey here is that as markets have normalized over time and the asset prices have reflated naturally returns available have more normalized, and we historically have had the benefit of higher rates of return on an opportunistic investments in the non-agency side as well as steeper curve investments in the agency side. And no one is immune from the spread tightening process that’s going on in the markets over the last several years. We’ve been more resistant to that for a number of reasons but nonetheless in the end it’s unavoidable that lower returns over time will result in lower earnings and therefore potential for lower dividend support.

Thank you. Our next question comes from Jason Stewart with Compass Point.

Hey, good morning.

Good morning, Jason.

Thanks for taking the question. And I wanted to ask you about the specified pools, and just from a broader perspective whether you think that value proposition has changed as credit has become more available and home prices improve or whether you think the performance in the second quarter was really driven by rates and over time those are still an attractive place to put capital?

So, good question, Jason. I think we still think there is an attractive value proposition there. We saw an increase sort of migration software in speeds in the late fall, really in the winter time that continues through the spring and what we’ve seen over the last couple of months is what looks like something trending towards more normalized, more traditional levels back towards the high single digits let’s say. It’s maybe too early to detect the trend there, but that certainly seems to us to be likely that without the driving rate where we saw earlier in the year that we’re likely to see speeds more normalized. We feel the value proposition continues to be there. Today, pay-ups are significantly lower than they were a couple of years ago and the value proposition there when we were talking about several points of pay-up value where it was maybe a little bit more challenging. Today with pay-ups here where they are, we still think the trade off or for the speed benefit is there.

Okay, that’s helpful. And does that foot with your expectations for – let me ask you this way, lower CPR so in that high – mid to high single digit range, does that foot with your low double digit ROE expectation? Is that the assumption you’re using there?

Yeah, obviously - there is potentially room for migration upward there if we see them really move back down to speed levels we saw from two years ago or three years ago which would have been more on the mid to high single digits. But even then at the – in the high single digits I think our view is that they can generate those low teen returns.

Okay. And one last one just along same [stock] [ph] prices and I’ll jump out. If we do see the private label re-remic market start to expand, what with the path of ROE – what would you expect it to look like there or maybe how would it compare to that low double digit ROE if you could put substantial capital to work where do you think that shakes out?

Well, I think it would be comparable to potentially higher but it would be as you recall from earlier investments we’ve made in the re-remic structure, it would be composed differently, so it would be composed in part of the current yield on that asset and in good part by the appreciation potential on that asset. And so the current returns would not be as high as the agency return and that example in the low teens, but the total return including expected appreciation would be higher because we’re taking that risk of the potential appreciation. Now, the other side of that also is that that investment in the non-agency structure in that way would be more on a unlevered basis which is beneficial, certainly at those levels of return that would be beneficial. And then also it would almost certainly be a post reset instrument so it would be variable rate. So the trade-offs there suggest a variable rate instrument, combination of current and expected return in order to take the risk on the expected appreciation part of that return you need to have a bit higher return and that would need to be closer to the mid teen, solidly mid teens to do that.

Okay, thanks for taking the questions.

Thank you. Our next question comes from Doug Harter with Credit Suisse.

Good morning, Rock.

Good morning.

I was hoping you could talk a little bit about the decision to kind of increase the portfolio, increase leverage in the face of a more volatile environment?

Well, I think Doug, we’re looking at it, at our risk adjusted return basis over time. I appreciate the question but we feel like the risk adjusted returns given the hedge magnitude that we have in place on that agency investment provide us with an opportunity to potentially reset that portfolio in a higher interest rate environment provided the rates move above our hedge costs – are hedge sort of basis rate. And so we feel like on that basis we can earn an acceptable low teens return all in current yield and protect against the longer term capital erosion that can occur from higher rates, meanwhile to the extent we see volatility in lower rates than we would expect to receive that over time back through the earning stream in the company.

Great, thanks. And then can you just talk about what you’ve seen and spread this on sort of your core agency products so far in July?

I wouldn’t say they’re – I think my description in the script looked at currently available economic given about a 3.15% yield and about a 1.90 hedge costs with the hedge constructed the way we do it. Now, there is a new one to that, there is a new one to that which is that those economics assume that the hedge are applied across all of the repo balance, the hedge notional has been running a bit below the hedge – excuse me, the repo notional and so as the consequence, there is a little bit of a pickup in return, as net return, net hedge return when you look out that way economically.

Sorry I should have been more clear, I guess I was thinking about spread from a book value perspective on how those have trended…

Yeah, pardon me Doug, I understand. I’d say we saw a bit of tightening and a pickup related to book post the end of the quarter and that is probably partially reversed itself in the last week or so with this rally. I’d say on the net, look these are moments in time and that they don’t relate well to financial statements at a quarterly in time. But I’d say on a net basis we’re probably a bit ahead from the end of the quarter.

All right, thank you Rock.

Thank you. Our next question comes from Richard Eckert with MLV & Company.

Yes. My questions have already been answered. Thank you very much.

Thank you. Our next question comes from David Walrod with Ladenburg.

Good morning, everyone. I just wanted to, on the private label MBS the migration from the capital allocation there to agencies picked up, I guess well, picked up during the second quarter. Can we expect that it to continue with that pace or was that just something great market opportunities which led to the higher conversion?

It’s market depend, Dave, so I think we did see some spread widening on the agency side during the second quarter and that gave us an opportunity to maybe apply a little bit more capital there from the non-agency portfolio than you’ve seem from the company over prior quarters. So again it’s market depend but a reasonable a look back overtime at the prior quarters is probably reasonable and if we have a supportive enough market in the third quarter then we may see volumes as high as the second quarter but that would be a little bit dependent on the supportive market and a wider spread opportunity in the agency side.

Okay, great. And then some of your peers has been looking to diversify their funding sources. I was wondering if you could talk about your funding and if you’re looking to do some of that as well.

Yes. We have been spending considerable time working on application to the federal home loan bank of Cincinnati through our captive insurance subsidiary Key Bridge Insurance and we have been notified that we have been accepted and approved as a member of the federal home loan bank of Cincinnati for future funding opportunities. I think we’ll – we’ll have more to say about that in the queue, but we’re pleased that to have been accepted as a member to become – approved to become a member of the FHLB at Cincinnati.

Today are you able to disclose at this time the amount [indiscernible] that you’re able to borrow through that source?

We’re not at that stage yet, as a broad matter the available capacity typically for companies as members of the FHLB at Cincinnati are quite significant relative to the overall funding base, more significant than I think we would use. So there is generally substantial capacity there as a percentage of the overall funding book available and we’ll determine that more specifically as we go forward and finalizing all aspects of our membership and as we begin to utilize that form of funding.

Great. Thanks for your time.

Thank you. Our next question comes from Daniel Altscher with FBR Capital Markets.

Thanks, and good morning, everyone. Appreciate you guys taking the call. We’ve spent a lot of time talking so far about return profile currently and maybe going forward, but what seems to have an outside is to return at least on a dividend basis actually in the stock relative to maybe what we’re seeing in agency line right now. So, how are we all thinking about the potential for share buybacks as actually an investment allocation?

Well, if those who have known us overtime know we have been bias of our stock in the past and we evaluate that in relationship to all our investment opportunities all the time. So it’s something that we have executed on in the past and then open to subject to a variety of factors, one of which obviously is the issue of scale and one of the things that people who follow us long enough, preferred us talk about the four is that there is that tradeoff between scaling down capital relative to G&A and the G&A burden on the capital and what that – what effect that has on returns versus buying stock. So these are things we look at very closely. We’ve executed on that before, we’re mountable to it generally and so we’re mindful of all these things. I think here as we sit here the stock is not a place that it probably meets those hurdles but it’s something we evaluate very closely all the time and it could be at any point, could be at any point an opportunity for us to capitalize on.

Okay. Just a quickie on the model, and I guess a new metric this quarter’s the core EPS expect gains on the sale private label, that maybe is the function because this quarter was a relatively large amount base line to call it out or do you think that’s maybe the way we should all just try to think about modeling the company with go forward is just exclude the gains, any potential future gains on private label?

Yean Dan, this is Rich. We presented it both ways this quarter and as you pointed out we got significant gains during the quarter which can be non-recurring and very significantly quarter-to-quarter. So, we thought it would be best interest to the shareholders and investors to see both presentations. And make [indiscernible] upon what measure they would rather measure us going forward on.

Okay. Thanks, that works. Related to the private label opportunity, I appreciate that we added a couple of million dollars this quarter into the new re-remics. I guess there are couple of other opportunities around in the non-agency role to others, maybe some new issue prime jumbo or some of the credits transfer, some of the new subordinated notes out there, the B-Classes. Have you looked at those at all or do you think the returns maybe there just aren’t attractive enough or they have to be too levered to get to returns that make them attractive, how are you kind of thinking about some of those alternative non-agencies now?

We examine each of these opportunities individually, constantly whether they might be in the re-performing space parts of the structured finance components of the re-performing securitizations, we look at each of the risk off trends – the agency risk sharing transactions. We think those are – we watch them closely, we evaluate what we think those expected returns on. We look at the legacy opportunities available to us and as we talk about before in the re-remic space we also look at underline legacy investments, those original front page AAA bonds that might support our re-remics or others like ours. And we look at the bonds in the legacy space that sit ahead of our re-remics, among a variety of other alternatives. As of yet, we’ve clearly not spend an opportunity that slates is an ability to remove the debt risk, the repo risk from those instruments when they’re levered. The asset level returns on those instruments typically would require leverage to achieve returns that are comparable to the agency side or justifiable for capital allocation in our view. And given that than one in evaluating, we in evaluating the debt risk associated with that, the mark-to-market risk associated with each of those asset have been more cautious on our view and have not felt that that risk justify the allocation of capital to those assets up to this point. So, that’s the process that we go through constantly in evaluating our alternatives and it relates back to the stock buyback as well. We align each of those opportunities up on our unlevered and levered basis versus the agency versus the stock and we evaluate those things constantly.

Okay, and I just want to follow-up on one other question which is actually I think it was Trevor’s question initially early on around the dividend policy. Can appreciate that potential for spread income perhaps decreasing if the spreads going to take some moves as it relates to potential dividend but at the same time if you look back in relatively short periods of history, I mean the core earnings power the company has also been lower and the dividend has remained unchanged. So, I understand the variable rate dividend and they’re seeing some unique characteristics that company allows on flexibility. So I’m just trying to bridge the gap thinking about the dividend if that can remain sustainable and still well covered even a period of compressing spread income given that the difference been unchanged even with lower core earnings in the past?

Well, I think there is a couple of aspects to that Dan, one of which is that keep in mind that the core – I think as we all know, the core calculation, core up income per share calculation includes net cash spread income and the gains from the non-agency securities. Rich explained the breakout between those two, but we also know that the changes in the hedge costs – excuse me, the economic cost of the hedge and amortization run through the book value of the company and are not reflective in that core operating income per share number. And when you detect those, those economic costs in total net out to a return number that is lower than the core operating earnings per share return on equity. A way to look at that is what I was trying to speak to at the end of the discussion which was that historically the company generated its earnings where a product of asset returns after detecting hedge costs and financing costs more in the high teens before G&A. And today of the consequence of the market normalization overtime, asset price reflation and lower returns, generally tighter spreads, those kinds of returns are not available at the asset level. And so as a consequence, the same level of earnings power is not available today and the dividend being based on the earnings power of the company on a quarter-by-quarter basis we evaluate that every quarter but just overall asset level returns on a hedged and finance basis, adjusted for amortization as well are lower than historical returns.

Okay, thanks. That’s a helpful clarification.

Thank you. [Operator Instructions] Our next question comes from Bob Evans with Pennington Capital. Bob, you may go ahead.

Hi, thanks for taking my question. The follow-up to previous question, I guess we understand that the return is lower and your margins have tighten. I guess if we look forward and project where your minds will be in the next quarter and your hedge and financing cost would be – it would appear that you’re – the current dividend level isn’t sustainable, I think everybody is trying to ask you this question in different ways but I guess the part of my question is are you going to normalize your dividend to what your earnings are which would imply that that dividend would need to be reduced next quarter versus having it remain at a level that would appear to be unsustainable?

Well, I think what I’m saying Bob is that we evaluated it on a quarterly basis. It’s based on the earnings power of the business, on the economic earnings power of the business. And the economic earnings power of the business has reacted overtime like all of these types of businesses due to market – shift in market, tightening spreads and will evaluate the dividend when it’s time in the third quarter. In consideration of the fact that the economic earnings power – the economic returns and earnings power of the company are probably more than anything we had been historically.

Okay. So would you say the economic earnings power as of what today would want the dividend being reduced?

It’s – we look at it on a quarter basis. At this stage, I’ve made the comment I’m prepared to make.

Okay, all right. Thank you.

Thank you. Mr. Tonkel, at this time we have no questions in queue.

Thank you everybody, we appreciate your time. And I’m as always available for follow-on questions if you might.

At this time, this concludes today’s conference. You can disconnect now.