C3.ai, Inc. (AI) Q3 2016 Earnings Report, Transcript and Summary

Good morning. I’d like to welcome everyone to the Arlington Asset Third Quarter 2016 Earnings Call. Please be aware that each of your lines is 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 Rich Konzmann. Mr. Konzmann, you may 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’d 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 uncertainties 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, 2015, 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.

Morning everyone. Welcome to the third quarter 2016 earnings call for Arlington Asset. Also joining me today are Eric Billings, our Executive Chairman; and Brian Bowers, our Chief Investment Officer. Before discussing Arlington’s results for the quarter, I’d like to begin by providing some commentary on the overall market. The third quarter began with uncertainty surrounding the global economic impact of the United Kingdom’s referendum vote supporting its exit from the European Union in late June that created pressure and risk asset prices and a flight to the safety of US treasuries, driving the 10 year US treasury rate to historic low of 136 basis points in the first week of July. However, as concerns regarding breaks have begun to subside and confidence in domestic economic conditions improved, investor appetite for risk assets increased during the quarter. These factors contributed to an 11 basis point net increase in the 10 year US treasury rate to 160 basis points as of quarter end, lower volatility and narrowing of fixed income investments spreads. In general, this resulted in interest rate hedges outperforming agency MBS during the quarter. Although the Federal Reserve kept its target federal funds rate unchanged in its most recent announcement, the Federal Reserve acknowledged that the case for an increase has strengthened, but that it will wait for further market data before making changes to its target federal funds rate. Market participants currently expect that it’s more likely than not that the Federal Reserve will raise its target federal fund rate 25 basis points at the end of the year. Repo funding capacity remained strong during the quarter with financing rates on agency MBS continuing to be competitive. The recent money market reform that went effective earlier in October drove withdrawals out of prime funds and into government funds, increasing the demand for short term repo backed by agency MBS, resulting in favorable financing rates. In general, this has led to an improved net funding cost of short term repo financing, hedged with interest rates swaps, as three months LIBOR rates received on interest rates swaps has increased more than the financing rates paid on repo financing. In the residential MBS market, historically low interest rates, steady home price appreciation and increased lender loan origination capacity have driven higher loan refinance volumes, leading to continued elevated prepayment speeds, thereby compressing agency MBS yields during the quarter. Against the backdrop of this overall investment climate, we believe agency MBS portfolios like Arlington's benefit from historically low funding rates, favorable hedging costs for extended periods, attractive investment spreads relative to other alternatives, provided they are adequately hedged as Arlington's are, as well as the prospect of potential upside in returns from lower prepayment speeds, and increased yields as a result, to the extent seasonal factors subside and interest rates stabilize. In sum, we believe these factors combine in a positive way to offer an attractive long term hedged return opportunity for shareholders and companies with agency MBS portfolio similar to Arlington's. Turning to the actual results for the quarter, we reported GAAP net income of $0.81 per diluted share. The company's non-GAAP core operating income was $0.64 per share, a $0.03 decline per share from the prior quarter, due primarily to higher prepayment speeds on our agency MBS portfolio. During the third quarter, the company generated an attractive economic return, provided a 17.9% annualized return on investable book value, from non-GAAP core operating income and declared a dividend of $0.625 per share. The weighted average CPR for our agency MBS during the quarter was 12.64% compared to a CPR of 11.4% in the prior quarter, and 10.3% in the third quarter of 2015. Since the company's agency MBS portfolio was purchased at a premium to par, faster actual prepayments can have a negative impact on the company's agency MBS yields, while slower actual prepayments can have a positive impact. As a reminder, the company's accounting policy is to recognize the impact of prepayment speeds on the agency MBS payment amortization, in the periods in which they occur. Due to the higher prepayment speeds this quarter, the weighted effect -- average effect of asset yield on our agency MBS declined to 2.6% for the third quarter, compared to 2.73% during the prior quarter. The lower effective asset yield on our agency MBS equated to approximately $0.05 per share decline in core operating income, as compared to the prior quarter. During the third quarter, the company's core operating income benefited from an improvement in the spread between the three month LIBOR rates that the company receives on its interest rate swap agreements, and the funding rate that it pays on its repurchase agreements financing that are based on one month LIBOR. The average rate the company receives on its swap agreements increased more than the average financing rate the company pays on its repo agreements during the quarter, which resulted in a positive contribution to core-operating income of approximately $0.01 per share as compared to the prior quarter, and could be of greater benefit going forward if the current spread between agency repo rates and LIBOR remains unchanged. As we previously discussed during our prior quarterly earnings calls this year and described in our investor presentation, we would like to reiterate that our core-operating income for 2016 is not directly comparable to amounts reported for 2015 with respect to our net interest expense from interest rates swaps, since the company began using interest rates swaps in place of futures in late 2015. As of quarter end, our book value per share was $18.83 per share. Our tangible book value, defined as GAAP equity less our deferred tax asset, was $14.63 per share as of September 30. The contributing factors to the increase in tangible book value were the outperformance of the interest rate derivatives relative to our agency MBS portfolio as long-term interest rates rose, while MBS spreads narrowed. Our interest rate hedging instruments increased in value by $0.58 per share while our agency MBS portfolio also increased by $0.18 per share for a net increase in the value of our hedge agency portfolio of $0.76 per share during the quarter. As of quarter end, the company's agency investment portfolio totaled $4.8 billion, consisting of $3.6 billion of specified agency MBS, and $1.1 billion of net long TBA agency securities. During the third quarter, the company increased its allocation to lower coupon 3% and 3.5% agency securities, and decreased its allocation to 4% agency MBS, thereby reducing the sensitivity of the portfolio to higher prepayments and reducing the volatility of the company's spread earnings. In addition, during the third quarter, the company increased its allocation to generic TBA securities from specified agency MBS within its overall agency portfolio in order to take advantage of higher relative risk adjusted returns in the TBA dollar roll market. As a reminder, TBA dollar roll income represents the economic equivalent of investing in agency MBS financed with repurchase agreement financing. The company specified agency MBS continues to be invested in 30 year fixed rate securities of specified pools, with characteristics selected for prepayment protection. The company’s specified agency portfolio as of September 30 was 85% comprised of low balance loans with the remaining portfolio comprised of loans with other low prepayment characteristics. During the third quarter, the value of the company's specified agency portfolio performed well, as pay-up premiums on our specified fixed rate agency portfolio remained relatively unchanged from our prior quarter at approximately 1 percentage point pay-up, despite the increase in long-term interest rates. The company continues to maintain a substantial hedge position with the intent to protect the company's capital, and earnings potential against increased interest rates over the long term. Our hedging strategy enabled the company to maintain an attractive return on its agency MBS portfolio in order to produce resilient and predictable core operating income that supports consistent dividends to our shareholders. As of September 30, the company had current interest rate swap agreements totaling $2.7 billion in notional amounts comprised of $1.25 billion of short-term interest rates swaps, with a weighted average maturity of 1.9 years, and a weighted average fixed pay rate of 106 basis points, and $1.5 billion of long-term interest rates swaps, with a weighted average maturity of 9.4 years, and a weighted average fixed pay rate of 189 basis points. In addition to the interest rate swaps, the company also had a series of put and call options on 10-year US Treasury notes futures to mitigate the interest rate sensitivity of the value of the fixed rate agency portfolio. As of quarter end, the company was long $600 million in put options at a weighted average strike price that equates to 171 basis point 10-year treasury rate, and was short, $600 million in call options, or weighted average strike price that equates to 139 basis point US treasury rate. In order to limit its exposure to the short call options in a significantly falling rate environment, the company was also long $300 million in call options at a weighted average strike price that equates to 10 year US Treasury of 107 basis points. In effect, the company moved options strike prices closer to the money during the quarter with the goal of further improving the responsiveness of the overall hedge position to rising rates, maintaining improved flexibility in a declining rate environment and reducing the overall cost of the options structure. At quarter end, the company had approximately 96% of investable capital directed to its hedged agency MBS portfolio and 4% allocated to the private label MBS portfolio, compared to an allocation of 86% to agency and 14% to private label at the end of the prior quarter. Turning to our private label portfolio at quarter end, the fair value of the portfolio totaled $21 million with outstanding repo financing of $6 million. During the third quarter the company sold private label MBS for sale proceeds of $68 million, and subsequent to quarter-end the company sold additional private label MBS for sale proceeds of $13 million. The company reinvested the capital from the sale of these private label securities during the third and fourth quarters, in the hedged agency MBS at expected higher relative risk adjusted returns. The company continues utilize its tax benefits afforded to it as a C-Corporation that allow it to shield substantially all of its income from taxes. As of quarter end, the company had estimated net operating loss carryforwards of $92 million and net capital loss carryforwards of $272 million. Based on its current investment in the hedge portfolio and the resulting improvement in the rate of usage of its tax benefits, the company expects that it will take over 3 years before we utilize its net operating loss carryforwards, although changes to the portfolio and actual higher or lower expected future income could change that estimate. From a book accounting perspective, the company had a deferred tax asset of $97 million or $4.20 per share. The company continues to record a substantial valuation allowance against a portion of its deferred tax asset attributable in net capital loss carryforwards for which the company is uncertain it will be able to utilize prior to their expiration. During the third quarter, the company recorded an increase of $2.7 million its valuation allowance against its deferred tax asset. The company's tax structure as a C-Corporation enables it to pay dividends to shareholders that are currently significantly higher on an-after tax basis compared to alternative yield oriented investment opportunities, including residential mortgage REITs with a similar investment profile. As a C-Corporation, distributions of the company's current or accumulated earnings and profits, our qualified dividend is eligible for the 23.8% federal capital gain income tax rate. Whereas, similar distributions to shareholders by a REIT or similar vehicles are not qualified dividends subject to a higher maximum 43.4% tax rate on ordinary income. Based on the most recent closing stock price, the company's current gross dividend yield is 16.6% compared to a median dividend yield of 11.8% for residential mortgage rates. However, when you compare the dividends on an after-tax basis, assuming that distributions are from current or accumulated earnings and profits, the company’s after-tax dividend yield is approximately 12.6% compared to approximately 6.6% for residential mortgage REITs, a substantial advantage. Overall, the focus of our agency investment and hedging strategy is to maintain the approximate scale and attractive return characteristics of our portfolio in order to create the pious present value opportunities for shareholders and deliver consistent dividends over time. During the third quarter, the company generated an attractive economic return, provided a 17.9% annualized return on tangible book value from non-GAAP core operating income, and declared a $0.625 dividend, continuing the company's consistent track record of delivering a robust dividend to shareholders over the last 27 quarters for a total of $20.66 per share. In addition to strong economic return and a high cash return on invested equity, the company recently made a number of governance improvements to advance the interests of shareholders. And finally, beyond the inherent alignment of interest associated with Arlington's internal management structure, the company's management purchased additional shares of the company's stock during the year to further align shareholder and management interests. The company remains committed to its shareholders' interests, and to delivering consistent dividends, and attractive long-term returns on a tax adjusted basis. Thank you very much. We look forward to taking your questions.

[Operator Instructions]. We now have our first question coming from Trevor Cranston from JMP securities.

Good morning. First question on the dollar roll positions that you guys added. Can you just give some color on the market in terms of how specially you were seeing the rolls when you were out of the positions, where you're seeing them today, if they continue to make sense to add to the portfolio? And maybe also what you think was driving the specialness in the third quarter. Thanks.

I think there's a variety of factors driving that, but the net effect was about -- depending on the point during the quarter, it was probably 20 to 40 basis point pickup in net yield during the quarter. I think we probably picked up in the end about -- near the higher end of that range versus cash back bonds, which is a good reason -- which is a substantial part of the reason why we made the transition of part of the portfolio out of some of the cash bonds and into the TBA. I think in addition, given the trend we've seen a little bit on the speed side, and the sense that maybe there are some structural things going on there that have shifted a little bit, I think we wanted to ease up a little bit on the cash bond side and reduce exposure at the margin to higher speeds, and take advantage of that through the roll at least on an interim basis. We look at it constantly. Today the roll is a little lower than it was at the point at which we entered into it. That's not unusual. You would typically expect to see it maybe widen out a little bit closer to when you get to the factors and settlement dates. We’ll see where it evolves over the next couple of weeks. If we view it as continuing to be a superior opportunity, we may maintain it around the same size. We may increase it and if it looks as if it's going to stay a little lower than it has, to the extent that it doesn't provide us with a substantial enough advantage in net yield over the comparable cash bond, then we may move some balance back to the cash bonds. That’s a investment decisioning process we're looking at every day and certainly every month when we refresh our looks at the role. And if there's a question as to whether why one wouldn't have more of a concentration at that point in time in the TBAs, the answer is sort of what I've just provided, which is that that can be a more opportunistic circumstance, and so you need to have a level of flexibility. Whereas the cash bonds can provide a more durable long term source of value creation. So you want to maintain your appropriate balance in that regard. So again we'll look at it over the coming weeks and make our adjustments based on where the roll is at that time.

Thanks. And a question on the options hedging portfolio. The put option, the 10 year is obviously trading, --10 year yield is trading higher than where the strike was on the put options today. Can you say if you’ve rolled all those positions and also just generally, is it a good idea for us to think about the strategy now being kind of a strike price maybe 10 to 15 bits over where the market is or how do you think about that?

Yeah, I think that's a fair assessment, Trevor. I think that’s exactly what we’ve sought do is bring the strikes closer to the money to give it more responsiveness. And I think the zone, the range of basis point cushion or strike above the current rates is a fair assessment from what had been historically a little bit more out of the money options to be more in that 10, 15 basis point range we feel like is a good place to be and I think the structure we're in gives us the ability to execute that, maintain and improve responsiveness to an up rate scenario, meaningfully improve flexibility in a down rate scenario and reduce the overall cost of the options structure.

Got it. Okay, appreciate the comments. Thank you.

Thank you. Our next question comes from Jessica Ribner from FBR & Co.

Hey, good morning. Thanks so much for taking my question. Just looking at your leverage on the agency portfolio this quarter, it ticked down about, from 10.1% to 9.5%. How do we think about that going forward and how do you think about it overall with CPRs where they are and the rate outlook kind of uncertain?

Well, I think a couple of things. During the quarter, what we observed, what we saw, what we did was we redeployed an additional amount of the non-agency private label book over to the agency side at higher relative returns. That implicitly has an effect on growing the portfolio because the agency investments are levered and the non-agency investments were largely unlevered. And so that has the effect of growing the portfolio at the margin and that has one effect on leverage. At the same time, we shifted as I said some of the balance from cash bonds to the TBA portfolio. Overall I think portfolio size was up a little bit as a consequence of those shifting factors. And I think from here, with the increase in speeds we've seen over the course of the year, we continue to be sanguine about the speed scenario, but it appears that there are a couple of structural factors that are at work here from an HPA perspective and incomes and job employment. There’s a boost in people's ability to qualify and capacity in the industry may have increased for refinancing. So we may just sort of see a little bit of a structural uptick. Typically we'd find ourselves here in the part of the season where you'd expect the speeds to be moving down. We would expect that to occur in the normal course. May or may not move down to the levels that they did last year into the high 7s and 8% range from what this past quarter was about 12.5%. But none of that really dissuades us from the larger conclusions, that while the net yield on the asset may move around at the margin from month to month based on changes in speeds, a little lower a little higher, even if you took some median, it's still a very attractive cash return on invested equity, to be able to invest in that asset, whether it's the cash backs or whether it's TBA roll. To invest in that asset with a spread that even today with this moving rates and a little bit of tightening of spreads, is still probably above 160 basis points net hedged to us, providing ROEs, cash ROEs in the mid to high teens. That’s a pretty compelling opportunity and so given -- especially given the way the portfolio and the magnitude in which it's hedged, I think we feel comfortable with where we are going into the sequence of events that may occur over the course of year end and into next year. I think we feel like the overall structure of the portfolio provides us with the hedged opportunity to deliver a consistent spread to people and that hasn't shifted over the quarter. It's just as true today as it was a quarter ago or -- and we'll see how events develop in the fourth quarter. If we get an improvement in speeds in the quarter, we'll obviously get a boost in yields and may get a pickup in returns. And we'll also see how this financing, the financing opportunity unfolds. We did see a benefit from the pay rate on swaps versus the --- excuse me, the receive rate on swaps versus the pay rate on the repo. And if that continues at the same level it currently is, and there's no way to know whether that will occur or not, but if that were to occur, we might get a pickup there, as well as from speeds if they decline. And obviously the big question is what impact does a Fed move have if they choose to go and that will be the other side of it.

All right, fair enough. Thanks so much.

Thank you. [Operator Instructions]. Our next question will come from Douglas Harter from Credit Suisse.

Thanks. Rock, with you guys being almost completely sort of migrated to agency at this point, are there any other assets that you're looking for that are attractive in the current environment?

Doug, it's a great question. It’s hard to say -- it feels like it's hard to say that things are cheap. I think we find relative value where we are. Again as you've heard us say before, we don't find any particular flaw at all in the non-agency opportunity, particularly the ones that we've owned and been a seller of. That’s just a -- as you know, a leverage question for us, a willingness to lever that sufficiently to generate enough return to come close to matching the agency side. And since we can't do it, since we're not comfortable leveraging it to that level, we're redeploying the capital to an opportunity where we are and we don't -- right now, we haven’t right now seen an alternative compelling circumstance. There are certain -- there are servicing strips and some of those types of assets have cheapened up some, and have improved in relative value, but right here right now, probably still don't quite achieve the standard to redeploy away from the agency side, given the hedge structure and the net economics that we can drive out of the agency side.

I guess along those -- How do you balance the trade-off between sort of the current return advantage that agency can offer versus having a diversification benefit from having a different asset class.

Well, keep in mind, as I think you may recall, at one point we were nearly 100% non-agency. So we're not at all unwilling to move capital in significant amounts and even sometimes quickly if warranted, to meaningfully higher risk adjusted opportunities, but the price, the cost of that allocation purely for the purpose of diversity today is very, very high. The assets that we're selling are wonderful assets in many risk adjusted return perspectives. Let's call it a high single digits, maybe a 10, but let's call it high single digits risk adjusted return unlevered and that asset is by any stretch a pretty attractive return opportunity on 175 basis point 10 year environment. But to give up something like 600, 700 hundred basis points of return to own that asset in the way that we predominately would want to own it, which is without much leverage if any, that penalty just feels like to too high a penalty to pay for the shareholders to pay. And if you do the risk adjusted return analysis, I think it justifies -- well justifies the allocation to the significantly higher return asset, given the way we can hedge it, and the cost at which we can hedge it, for the duration of time at which we can hedge it.

Makes sense. Thank you.

Thank you. Is there anything -- that’s it? Okay, thank you everyone. We appreciate it. Have a nice day and if you have further questions, please don't hesitate to call us.

Thank you ladies and gentlemen. This concludes today's teleconference. You may now disconnect.