C3.ai, Inc. (AI) Q2 2017 Earnings Report, Transcript and Summary

Good morning. I'd like to welcome everyone to the Arlington Asset Second Quarter 2017 Earnings Call. Please be aware that each of your lines is on 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. 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, risks 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 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 statements. 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 of 2017 earnings call for Arlington Asset. Also joining me on the call today are Eric Billings and Brian Bowers. During the second quarter, the bond market signaled tempered expectations for faster economic growth and higher inflation, resulting from potential pro-economic growth policies following the November elections, including potential tax reform, infrastructure spending and deregulation, while the equity markets continue to price in higher optimism for growth and inflation. In response to this backdrop, the 10-year U.S. Treasury rate rallied for most of the quarter, reaching a low of 2.1% in June before ending at 2.31% as of quarter-end, an 8 basis point decline from the March 31 rate. Additionally the Treasury rate curve continue to flatten during the quarter as the spread between the two year and 10-year U.S. Treasury rate narrowed 20 basis points. Although the spread between 10-year U.S. Treasury rates and interest rate swaps tightened modestly during the quarter, two year swap spreads declined significantly by 12 basis points. As widely expected, the Federal Reserve raised its target federal funds rate in June by 25 basis points, the third increase in the six-month period. Market expectations were further rate increases this year have declined from the prior quarter. And based on federal funds futures prices, market participants currently expect that there is less than 50% chance that the Federal Reserve will raise rates again in the fourth end of the calendar year. In its June statement, the Federal Reserve expanded further on its previously announced balance sheet normalization policy by signaling that it began implementing a normalization program later this year by gradually decreasing its monthly reinvestments. In that environment, 30-year Agency MBS underperformed modestly as the market continue to contemplate the impact of the Federal Reserve's pending diminished role in the Agency MBS market. On the other hand, repo funding capacity remained strong during the quarter with financing rates on Agency MBS continuing to be competitive as demand for short-term repo backed by Agency MBS remains strong. Prepayments fees during the first two months of the second quarter were relatively benign before increasing somewhat in June in part due to seasonal factors. Looking forward, near-term prepayments fees are expected to remain moderate subject to normal seasonal variations. However continued wage growth, home price appreciation and the recent downward movement in long-term interest rates for a bit in the second quarter may accelerate prepayments fees somewhat from the current levels. Turning to the actual results for the quarter. We reported a GAAP net loss of $0.74 per share and non-GAAP core operating income of $0.58 per share, a decline of $0.02 per share from the prior quarter. The company declared a dividend of $0.55 per common share for the second quarter, it's second change to its common stock dividend in 25 quarters. Core operating income per share for the second quarter benefited from higher average investment volumes and moderately lower G&A expenses. However these benefits were more than offset by the higher average cost of funding, driven primarily by the [Technical Difficulty] March and June interest rate hikes. Although Agency MBS prepayments fees increased modestly during the second quarter, the company's weighted average investment yields remained unchanged from the prior quarter. The weighted average CPR for our Agency MBS during the second quarter was 9.03%, an increase from 8.17% in the prior quarter, while weighted average reflective asset yield on our Agency MBS was 2.85% for the second quarter, unchanged from the prior quarter. Looking forward to the third quarter. Prepayments fees were a relatively higher to start the quarter with weighted average CPR for July at 10.55%, in part due to normal seasonal factors, which we expect would resolve in a weighted average effective asset yield of approximately 2.77% for the month. Net interest spreads available on TBA dollar rolls were favorable in the quarter compared to Agency MBS funded with repo. For the company's TBA dollar rolls, the implied net interest spread was 2.42% for the second quarter compared to 2.45% for the first quarter. For the second quarter, our average investment balances were higher than the prior quarter, which contributed to an increase in core operating income of approximately $0.03 per share compared to the first quarter. As we stated in our prior quarter earnings call, we increased our overall Agency portfolio towards the end of first quarter to prior levels as prepayments fees began to stabilize late in the first quarter leading to most attractive returns. All-in funding cost increased from the prior quarter, contributing to a decline in our core operating income of approximately $0.07 per share compared to the first quarter. The weighted average funding rate on our repo financing during the quarter increased 18 basis points from the prior quarter to 108 basis points, driven primarily by higher benchmark rates due to the Fed hikes in both March and June. However the impact of the funding cost rise in LIBOR from the Fed rate hikes was mitigated by narrowing of the spread between LIBOR and repo financing rates as conditions in the Agency repo market and pricing continue to be favorable. For the quarter, the spread between average one-month LIBOR and our average repo financing rates narrowed approximately 5 basis points compared to the last quarter to 2 basis points. The funding cost of our repo financing increased to 1.33% as of the end of the quarter due to the June fed rate hike as well as repo providers demanding higher rates related in part to common quarter-end balance sheet patterns. The spread between one-month LIBOR and our repo financing rates was 11 basis points at quarter end. And looking forward to July, our repo funding cost improved from end of last quarter by approximately 2 basis points. As of quarter-end, our book value was $13.48 per common share. Our tangible book value, defined as GAAP common equity less our deferred tax asset, was $12.55 per share, a decrease of 4% from the prior quarter. The decline in tangible book value per share was attributable to the modest underperformance in the price of the company's Agency MBS relative to its interest rate hedges, particularly within the company's higher coupon Agency MBS. In addition, Agency MBS portfolio is hedged primarily with the interest rate swaps, such as the company's underperformed similar portfolios hedged with the U.S. Treasuries as a result of the tightening of interest rate swaps during the quarter. As of quarter end, the company's Agency MBS portfolio totaled $5.3 billion, consisting of $4.2 billion of specified Agency MBS and $1.1 billion of net long TBA securities. During the second quarter, the company increased its allocation of agency TBAs while lowering its position of specified Agency MBS as a net spread opportunity of TBA rolls with moderately higher than the net interest spread returns of specified Agency MBS financed with repo funding. As of June 30, the Agency TBA position represented 22% of the company's overall Agency investment portfolio compared to 10% as of the end of the prior quarter. The company maintains a substantial hedge position with the intent to protect the company's capital and earnings potential against rising rates over the long-term. Our hedging strategy enables the company to maintain an attractive return on its Agency MBS portfolio in order to produce resilient and predictable core operating income that supports attractive dividends to our shareholders. The company primarily uses interest rate swaps supplemented with 10-year U.S. Treasury note futures to hedge interest rate risk. During the second quarter, the weighted average notional amount of the company's interest rate hedges as a percentage of repo and TBA commitments was 74%, a slight increase from 72% in the prior quarter. As of June 30, the company had interest rate swap payments totaling $3.5 billion in notional amounts comprised of $975 million of short-term interest rate swaps, with the remaining weighted average maturity of 1.7 years and a weighted average fixed pay rate of 1.18%; $500 million of medium term interest rate swaps with a remaining weighted average maturity of four years and a weighted average fixed pay rate of 1.91% and $2 billion of long-term interest rates swaps with the remaining weighted average maturity of 8.9 years on a weighted average fixed pay rate of 2.01%. The company also had forward starting two-year interest rate swap that become effective in September and October of 2017 with a weighted average fixed pay rate of 1.13%. In addition to interest rate swaps, the company also held $350 million in notional amount of short positions in 10-year U.S. Treasury note futures as of June 30, to mitigate the interest rate sensitivity of the value of its fixed rate Agency portfolio. To limit the exposure of its overall interest rate hedge portfolio in a significantly falling rate environment, the company also was long $700 million in call options in 10-year U.S. Treasury note futures as of quarter-end at a weighted average strike price that equates to a 10-year U.S. Treasury rate of 1.81%. The company continues to utilize its tax benefits afforded to it as a C-Corporation that allow it to shield substantially all of its income taxes. As of quarter-end, the company had estimated net operating loss carry-forwards of $75 million; net capital loss carry-forwards totaling $324 million and AMT credit carry-forwards of $9 million. Based on its current investment and hedge portfolio, the company expects that it will utilize its net operating loss and AMT credit carry-forwards during the latter half of 2019, although changes for the portfolio and actual higher or lower than expected future income could change that estimate. From a book accounting perspective, the company had a deferred tax asset of $24 million or $0.93 per share as of quarter, which now reflects a full valuation allowance against all the company's deferred tax assets that are capital in tax nature. Overall hedged Agency investment returns continue to remain attractive with focus of Arlington's investment strategy and hedging strategy continues to be and maintain the approximate scale and attractive return characteristics of our portfolio in order to generate a resilient and consistent spread income streams to support attractive dividends over time and deliver the highest present value opportunity for shareholders. After delivered $22.44 per share of dividends to common shareholders over the last 30 quarters, the company remains committed to the interest of shareholders and to delivering dividends, which continue to support attractive long-term returns to shareholders on an after-tax adjusted basis. Thank you. We would be happy to take questions.

At this time, we will open the floor for questions. [Operator Instructions]. Our first question comes from Jessica Levi-Ribner with FBR.

Good morning, guys. Thanks for taking my question.

Good morning, Jessica.

One on the shift from more TBAs versus spec for this quarter. What determines that shift and how do we think about it going through the third quarter?

Well, as I said in the remarks, the driver was simply what we felt was a better risk-adjusted spread opportunity in the TBAs at the time versus specs. And as we've talked about before that's sort of a judgment we make at the margin month-by-month as TBA rolls shift and to the extent that at the given point in time, maybe - they maybe more attractive, say, all things taken together relative to specs. Then we'll allocate more capital to the TBAs and more balance sheet and more capital to the TBAs. And if we find that specs appear relatively expensive at the margin, relative to TBAs at a given point in time, we will adjust that accordingly. So that's sort of a toggle at the margin based on achieving the better risk-adjusted return for the overall portfolio.

Okay. And then just one on your comment about the dividend. How can we think about that going forward and kind of wrapped up in that is, what your expectations for rate hikes and interest rates are going to be and earnings power on the back of that?

Well, as you know, probably the largest drivers beyond simply the scale of the portfolio, and to some degree the mix, but the largest drivers are our going to be prepayments fees and marginal funding rates. So we are quite substantially hedged but there is a unhedged portion of our repo book. And so when we see when the Fed makes its adjustments from a rate perspective, then that flows through to the funding line, I think, the change in the dividend, we've tried to be pretty clear that that was a result primarily of the cumulative effect of the Fed rate increases on the unhedged portion of the book principally over the last six months. And I would say from here, when we look at the dividend change, we took into consideration what we felt was the core and ongoing earnings power of the portfolio in the environment at that time, which to us doesn't seem to have changed materially today versus then. And I think the drivers from there will be are there meaningful additional rate hikes from the Fed and what is the course of prepayment speeds over the remainder of the year etcetera going forward into the future from here. Last year, we saw speeds that were more elevated in the back part of the year based on the spike downward in rates that was extended for a period of time and created a window for accelerated prepayments. We can't say whether that's happened this year or not. We don't have reason to expect it but there is of course political uncertainty that we're all living in that can create unusual scenario. So I would say we wouldn't expect in the normal course. The speed this year would be as accelerated as they were last year because of the rate levels and other factors in the overall mortgage prepayment environment. But that would be a large determinant of the spread earnings, and therefore, the reported core earnings of the company going forward. So I think when we set the dividend, we try to take into consideration what we thought would be reasonable and normal seasonal patterns in prepayment speeds based on the environment we are in, and we feel like we set the dividend in a level that reflected the ability to absorb some changes in speeds over time but if the Fed makes meaningful additional moves and/or speeds are meaningfully higher, then those are things that we can't control and will have their own effects. Outside of that, we feel like we're - the dividend is generally reflective of the earnings power of the portfolio at this scale and mix.

Okay. I appreciate that. Thank you.

And our next question comes from Trevor Cranston of JMP Securities.

Hi, thanks. Good morning. It looks like leverage on the portfolio, if you include the TBA position, increased moderately this quarter. Can you talk about how you're thinking about that currently? And with spreads widening somewhat during the second quarter, if you view agencies as attractive enough to continue growing the portfolio, if you're just comfortable with the size of it as of June 30? Thanks.

Well, I think the growth in the portfolio was driven in large part by the incremental capital. And so we would look at the opportunity today and say yes based on the spreads available today, particularly as they widen a bit over the course of the quarter and represent an attractive opportunity. So to the extent that there is capital from prepayments or otherwise to deploy, then I think we would feel comfortable deploying that into this spread environment in the agency space. So I think we - and whether we do or whether we don't, incrementally will depend on of course, as you know, Trevor, what the pace of runoff is and to the extent they were capital raising opportunities going forward, which would be speculative on my part to guess about.

[Operator Instructions]. And next question comes from Doug Harter of Credit Suisse.

You talk about wanting to deliver the best returns. How are you balancing the leverage which is at the higher end of peers versus a dividend, which is also at the high-end and how are you balancing that versus taking down risk and delivering a lower return but potentially less volatility in book value and/or earnings given where we are?

Well, I think, Doug, that I don't feel like we have really a different answer than we've shared before our approach and our philosophy is to take advantage of those wider spreads and maintain the approximate scale of the portfolio based on our existing invested capital in it, and therefore by maintaining that approximate scale and taking advantage of those higher spread opportunities and the possibility that comes from them to deliver that benefit to the shareholders to maximize their present value of outcome. And so I think there is not really a change there. And what's governing us there is the marginal return attractive relative to other alternatives that are available to us and compelling versus the existing return in the portfolio. And if that's the case, then we would expect in a normal course to continue to reinvest at the margin into a higher spread environment.

Got it. Thank you.

Our next question comes from David Walrod of Jones Trading.

Hi Dave.

Yes, good morning. I just wanted to expand a little bit on a couple of things. First of all, you talked about the Fed and the outlook for rate increases has been a little more tempered. Can you talk about, I guess, any changes you made in the portfolio or in your hedge book in response to these kind of a more nuanced outlook?

Sure. I think we found during the quarter the incremental profitability of not just the TBAs but at the margin forced to be a little bit more favorable than sort of three-and-a-halfs and so we made somewhat of incremental shift there. And I think in the context of that, we - of the context of our view and may be a bit more focused on a front-end that maybe - front-end of the curve which may be continuing to move up as the Fed goes along its work whatever pace they choose to move up funds rates at, we add an incremental hedges in the short-end sort of three year tenor, and at the same time as we incrementally grew the portfolio, we added some long-end protection as well in incremental futures against the TBA portfolio. As the TBA portfolio grew, we incrementally added futures. And as we start to emphasize a little bit more of the front-end sensitivity to future rate hikes, we added some three year swaps. And that let the duration, the overall duration of the hedge, about the same maybe a tiny little bit longer, a little bit higher in repo coverage, a little bit higher hedge coverage with a repo position at 74% versus 72%.

Okay, that's helpful. And then just kind of a basic question. You've obviously got the portfolio and 100% Agency MBS. In your investor presentation you note the possibility of investing opportunistically in other asset classes. Is there anything specifically you're looking at or is that just kind of a generic we look for opportunities?

Well, as you know, we've looked at different alternatives over time and I would say particularly right now with overall investment spreads where they are and available returns as tight as they are, that the Agency opportunity here on a hedge basis with, call it 3.10 or thereabouts yield and about 180 - 175, 180 basis point all-in cost of floating funding and hedge funding, leaves you at neighborhood of 130 points little bit more. To us that seems like an appealing opportunity with the inherent protection to it from the government and from liquidity of that market, against many other alternatives that we are reviewing from time to time. And so there is nothing apparent right at the moment that jumps out at us. We've reviewed different alternatives, and at the moment, we feel like incremental capital to the extent it's available would go to the agency side.

Okay. Thank you.

Mr. Tonkel, there are no further questions at this time.

Okay. Thanks very much folks. If you want to have any further questions or thoughts, just please pick up the phone. Thank you.

Thank you, ladies and gentlemen. At this time, you may now disconnect.