C3.ai, Inc. (AI) Q3 2017 Earnings Report, Transcript and Summary

Good morning. I'd like to welcome everyone to the Arlington Asset third quarter 2017 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 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 statement. I would now like to turn the call over to Rock Tonkel for his remarks.

Good morning, everyone. Thank you for joining us. Also, joining me on the call today are Eric Billings, our Executive Chairman, and Brian Bowers, our Chief Investment Officer. Before discussing the specifics of Arlington's results for the quarter, I would like to begin by providing some overall market commentary. Up until mid-September, the waning likelihood of potential pro-economic growth policies and geopolitical concerns lowered market participants' expectations that the Federal Reserve would raise rates again this year. Although the Federal Reserve kept the target federal funds rate unchanged following its September 20 meeting, the markets generally viewed the commentary as hawkish based on the Federal Reserve's commitment to raising the target federal funds rate in the near future and beginning its balance sheet normalization policy in October. Subsequent to quarter-end, the congressional path towards potential tax reform has raised economic growth expectations driving interest rates higher. In the next couple of weeks, President Trump is expected to nominate a chair of the Federal Reserve to serve a four-year term to begin after Chair Yellen's current term expires, with several candidates, including Chair Yellen under consideration. The selection of the chair is being carefully watched by the market, particularly as it relates to policy rate path and balance sheet normalization pace. Based on federal funds futures prices, the market participants are currently expecting that the Federal Reserve will raise rates in December. Against this backdrop, the 10-year U.S. Treasury rate rallied for most of the quarter, reaching a low of 2.04% in early September, the lowest point since the presidential election. However, post the Federal Reserve September statement, yields on the 10-year treasury rose, ending at 2.33% as of quarter end, resulting in only a 2-basis point increase from June 30. The treasury rate curve continued to flatten during the quarter, albeit at a slower pace than in prior quarters as the spread between the 2-year and 10-year treasury rate narrowed 8 basis points. In this environment, agency MBS outperformed the US treasuries during the third quarter as agency MBS investment spreads narrowed, driving hedged agency MBS book values higher. Repo funding capacity remains 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. Overall, prepayment speeds in the residential mortgage market were higher than the prior quarter, driven by the interest rate rally last quarter as well as continued home price appreciation and wage growth. Looking forward, near-term prepayment speeds are expected to moderate and asset yields increase due to the current interest rate environment and normal seasonal impact. In short, agency MBS spreads tightened during the quarter, driving book values higher. At the same time, prepayment speeds and the overall funding costs rose, diminishing core earnings for the quarter. However, based on current market conditions, we expect lower seasonal and rate-driven prepayment speeds to result in higher asset yields in the fourth quarter, which combined with the reversal of the repo versus the interest rate swap lag effect in the third quarter would elevate economic spread income about third-quarter levels. Turning to our actual results for the third quarter, we reported GAAP net income of $0.85 per share and non-GAAP core operating income of $0.52 per share. For the third quarter, the company declared a dividend of $0.55 per common share. The reduction in core operating income from the prior quarter was due to higher prepayment speeds resulting in lower investment yields, higher net funding rates from the Fed June rate hike, lower leverage in the investment portfolio, and partially offset by lower G&A expenses. The weighted average CPR for our specified agency MBS during the quarter was 10.29%, an increase from 9% in the prior quarter, resulting in a weighted average effective asset yields on our agency MBS of 2.8% compared to 2.85% last quarter. The lower weighted average asset yield contributed to an approximately 2% – sorry, $0.02 per share decline in core operating income during the quarter. Looking forward, prepayment speeds experienced a modest decline to start the fourth quarter, with a weighted average CPR for October at 9.71%, which we expect would result in a weighted average effective yield of 2.84% for the month. As expected, all-in funding costs increased from the prior quarter due to the full-quarter effect of the Fed's June rate hike and contributed an approximately $0.03 per share decline in our core operating income compared to the second quarter. However, approximately $0.02 per share of this amount is attributable to a timing lag between our repo funding, which is generally repriced each month, and the receive lag of our interest rate swaps, which is reset every three months. All else being equal, this lag amount should reverse itself in future periods. The weighted average funding rate on our repo financing increased 23 basis points to 131 basis points, driven primarily by higher benchmark interest rates due to the Fed's 25 basis point rate hike in June. In October, repo funding costs improved from the end of the quarter by approximately 2 basis points. The implied net interest spread available on TBA dollar rolls during the third quarter continued to compare favorably to the net interest spreads on specified agency MBS financed with repo funding. However, the relative advantage of TBA dollar rolls declined somewhat during the quarter. The TBA net interest spread was 2.10% compared to 2.42% in the prior quarter, which contributed to an approximately $0.03 per share decline in core operating income. For the third quarter, our overall investment volumes were lower, resulting in lower average leverage compared with the prior quarter, in part due to the timing of the investment of capital raised from our ATM equity program, which contributed to an approximately $0.02 per share decline in core operating income. Core G&A expenses declined during the quarter, which combined with the improved operating leverage from the incremental capital raised during the quarter, benefited core operating income by $0.03 per share. As of quarter-end, our book value was $13.71 per common share. Our tangible book value, defined as GAAP common equity less our deferred tax assets, was $12.88 per common share as of September 30, an increase of 2.6% from the prior quarter. The increase in tangible book value per share was attributable to spread tightening experienced through the outperformance in the price of the company's agency MBS relative to its interest rate edges. As of quarter-end, the company's agency MBS portfolio totaled $5.4 billion, consisting of $4 billion of specified agency MBS and $1.4 billion of net long TBA agency securities. During the third quarter, the company increased its allocation of agency TBAs, while lowering its position of specified agency MBS as the net interest rate opportunity of TBA dollar rolls continued to be moderately higher than the net interest spread returns of specified agency MBS financed with repo funding. As of September 30, the agency TBA position represented 26% of the company's overall agency investment portfolio compared to 22% as of the prior quarter-end. The company maintains a substantial hedge position with the intent to protect the company's capital and earnings potential against rising interest rates over the long-term. The objective of our hedging strategy is to enable the company to maintain an attractive return on his 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 and, from time to time, options on U.S. Treasury note futures and agency MBS to hedge its interest rate risk. During the third quarter, the weighted average notional amount of the company's interest rate hedges, as a percentage of its repo funding and TBA commitments, was 78%, a slight increase from 74% in the prior quarter. As of September 30, the company had interest rate swap agreements totaling $3.6 million in notional amounts, with a fixed average pay rate of 1.66% and a weighted average remaining maturity of 5.2 years. In addition, the company had $250 million in notional amount of forward starting 2-year interest rate swap agreements that become effective in October, with a weighted average fixed pay rate of 1.12%. The company's weighted average net pay rate of its interest rate swap agreements was 0.4% during the third quarter compared to the 0.62% last quarter. In addition to interest rate swaps, the company also held $350 million in notional amount of short positions in U.S. Treasury note futures as of September 30. The company continues to opportunistically raise equity capital to take advantage of investment opportunities that would be accretive to shareholders. As an internally managed company issuing equity capital also allows the company to improve its G&A expense operating leverage that increases its ROE to shareholders. During the third quarter, the company issued common and preferred equity through its equity ATM program for net proceeds of $30 million. And year-to-date, through September 30, the company has issued equity capital for net proceeds of $67 million and benefited from a resulting lower expense to capital ratio. The company continues to utilize its tax benefits afforded to it as a C corporation that allow to shield substantially all of its income from taxes. As of quarter-end, the company had estimated net operating loss carryforwards of $70 million, net capital loss carryforwards totaling $310 million, and AMT credit carryforwards of $9 million. Based on its current investment in the hedged portfolio, the company expects that it will utilize its net operating loss and AMT credit carryforwards towards the end of 2019, although changes to the composition and size of the portfolio and actual higher or lower-than-expected future income could change that estimate. Overall, hedged agency investment returns continue to be attractive. The focus of Arlington's agency MBS investments and hedging strategy is to maintain the stability, approximate scale and attractive return characteristics of our portfolio in order to continue to generate a consistent and resilient spread income stream to support attractive dividends over time and deliver the highest present value opportunity for shareholders. Having delivered $23 per share of dividends to common shareholders over the last 31 quarters, the company remains committed to the interest of its shareholders and to deliver dividends which continue to support attractive long-term returns to shareholders on an after-tax basis. Operator, I would now like to open the call for questions.

Thank you. [Operator Instructions] The first question will come from Jessica Levi-Ribner with FBR Capital Markets. Please go ahead.

Good morning, guys. Thanks so much for taking – how are you?

Good.

My first question is just around tax reform here and how you think about the tax reform proposal vis-à-vis your NOLs and carryforwards losses and if that changes kind of your strategy at all?

Hi, Jessica. This is Rich. I don't think the pending tax reform is going to change our path of utilizing our NOLs. I don't think it will have a meaningful impact on the timing of the utilization of the NOLs or how we would – it wouldn't make any modifications to our structure or anything like that in anticipation or in response to that. I don't think that…

Okay. And then, in terms of the dividends, Rock made a couple of comments that if the swap, repo kind of have a lag, how it happened, there would be another $0.02 of earnings. When we look into the next quarter and kind of – this one is a tougher one – into 2018, do you see the ability to kind of earn the dividend on a core basis, all else being equal, right, no jumps in rates or anything like that?

Well, I think, Jessica, look, our overall approach is to maintain consistency to the best extent we can of the income stream of the portfolio, sustain the highest dividend we can sustain, highest dividend stream we can sustain over the long term for shareholders to promote the highest present value opportunity for shareholders. So, I think, specifically, in the third quarter and what we've seen so far in the fourth quarter supports what I said in the script here, which is that the funding lag was worth a couple of pennies, the higher speeds in the third quarter were worth a couple of pennies. And all else being equal, to the extent that those reversed themselves in the form of lower seasonal speeds and potentially rate-driven speeds of these interest rates in the fourth quarter, then you would presumably see some reversal of those impacts. Will it be exactly the same? There's no way to say whether it would be exactly the same or not. But I think those numbers are fair representation of what the impact would be if those couple of factors reversed themselves in the fourth quarter. And I would think that sort of answers the question in and of itself from a math perspective.

Okay, thank you. That's it for me.

Thank you for your question. The next question will come from Doug Harter with Credit Suisse. Please go ahead.

Thanks. Can you talk about your desire or willingness to continue to use the ATM program and how you're thinking about leveraging that incremental capital?

Well, Doug, you've observed us over time. I think we try to be very disciplined about adding capital accretively. And the ATM product assists in that process because it provides for a very low cost of capital raising relative to other alternative forms. So, it's appealing in its nature as a capital raising and growth element to the business. And when it is appropriately accretive, then we expect to be able to take advantage of it. We would hope to be able to take advantage of it going forward with the notion that, number one, it would have to be sufficiently accretive; and number two, it would feed into the objective to reduce the expense-to-capital ratio and improve earnings and ROE accordingly as we saw that it did in the third quarter and the second quarter. So, if it's sufficiently – if it's priced at a level that's sufficiently accretive to us, then, yes, we would expect to continue to use that tool to improve the capital and what profitability position of the company. I think, from a leverage perspective, our broader goal is to sustain the consistency of the income stream and add to it where we can. I think – but you saw a little bit of shift in leverage in the quarter and I think, over time, to the extent that that ATM is available to us, then I suspect you may see – I don't think it would surprise anyone to see us – to see maybe at the margin leverage tick down accordingly over time.

Great, thank you. And just on the concept of accretion, I guess, how do you think about the deferred tax asset and the value of that when factoring in kind of whether the current price is accretive versus looking at tangible book value?

Well, as we've talked about, I think, over time, there's an element of consideration for that in a couple of ways. But one particular way is essentially a present valuing of that instrument – of that asset in consideration, but it's a broader calculation. It necessarily brings into effect the earnings accretion, the capital accretion and the impact on the – natural effect on the expense-to-capital ratio and the ROE. So, all those things are in it together, the present valuing of the DTA comes into effect in that discussion. But since it's time frame is now shorter, its remaining life is now shorter, it has incrementally less significant an impact on that determination, but it still has a role in that determination of sufficient accretion in order to move forward and execute on the ATM or the stock at a given price.

Makes sense. Thank you.

[Operator Instructions]. The next question will come from Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Hi. Thanks for taking my questions. Following up on the tax reform question earlier, if tax reform does go through, should we expect a write-down to the DTA, Rich?

Yeah. Yeah, Chris. This is Rich. So, to the extent that the corporate income tax rate changes, if it goes down, then by whatever percentage it goes down, the deferred tax asset will go down too because that's simply your growth tax benefits multiplied by the corporate tax rate. That's what is reflected on the balance sheet. So, any company that has a deferred tax asset, to the extent that there is a change in the corporate income tax rate down, would result in a reduction in your deferred tax asset.

Great. And is it fair to say that you guys are pretty much at your capacity in terms of TBA securities?

I couldn't understand the last part of that question, in terms of what?

The TBAs?

Oh, is it fair to say that we're at the max?

Yeah, correct.

We have that portfolio positioned at between 10% and 25% or so of the overall portfolio. That isn't to say that it couldn't go higher because there may be circumstances under which either, A, the spread differential was sufficiently favorable that you might want to increase upon there or the liquidity differential in certain periods of time would potentially make a difference in that determination. So, it's not to say that you wouldn't go higher, but we're sort of in the range of the higher bound. I don't think, at this stage, we necessarily would anticipate it going higher, but that isn't to say that would never happen because there could be circumstances from a profitability perspective or liquidity or flexibility otherwise that you might take advantage of there. As we see things right now, I don't know that we see it going meaningfully higher from there.

Okay. Final question. Compensation and benefits expenses ticked up in the quarter. Anything driving that in particular?

Yeah. So, what you're looking at, Chris – this is Rich again – is the GAAP compensation and benefits line item on our income statement. And included in that is stock-based compensation related to our performance-based stock compensation. And under GAAP, for certain of those, depending upon the performance measures that are based upon book value changes, you have to true-up each quarter what the expected performance measures are. So, in a period where you have book value decline, you could end up having to reverse out a bunch of stock compensation that was attributable to prior periods, which is what happened last quarter. This quarter, when you had the book value go up and the performance measures increase, you end up bringing some of that back on to the income statement. So, what you saw quarter-over-quarter was really just – frankly, a lot of noise, if you will, that's kind of going back and forth between – because of the book value changes. So, the comparability between quarter to quarter is impacted, what I would call, by out-of-period true-ups that are required under GAAP accounting. If you exclude the stock-based compensation numbers out of there, the comp and benefits line item actually declined on a quarter-over-quarter.

That's it from me. Thank you.

Chris, if you want, we can delve into details in terms of how all that works and the stock compensation offline, if you will.

Yeah. I'll follow up with you later on, Rich. Thank you.

Thank you for the question. The next question will come from Trevor Cranston with JMP Securities. Please go ahead.

Hi, Trevor.

Hi, thanks. A couple of questions on the portfolio. First, it looks like, within the MBS portfolio, there is a bit of a shift down in coupon this quarter. Can you talk about what drove that and, incrementally, where you guys are investing pay-downs? So, within the capital sect or within the coupon sect? Thanks.

Mostly relative return driven in the third quarter. And I'd say, today, at the margin, probably more toward 4s would be sort of both the priority of allocation today and that's the simple answer of the question. If you want me to expand on it then – if you've got a more nuanced question, go ahead and ask it, but that answers the question on the surface.

Yeah, that's good enough. And then, on the hedged portfolio, it looked like within the options that there is more of an emphasis this quarter on put options on MBS as opposed to the treasury options you guys have used in the past. Can you just talk about how you think about using MBS options versus treasuries? And maybe, in general, how you guys are thinking about optional hedges, given the low level of volatility currently and your outlook for rates?

Well, the option cost dynamic has shifted a little bit in the last few weeks, most predominantly since the end of the quarter. And so – and it's moving around, given the positioning that people are doing around the rate direction, given potential tax reform and who the Fed chair becomes. But during the third quarter, I'd say, dialing out a little bit, zooming out a little bit, Trevor, I'd say that the emphasis there was probably a little bit of a switch from options based hedging to more fixed-rate driven managing. And you can see that in the bit of an increase in hedged portions and to the total notional. So, there is a little bit of less emphasis on the options side in the third quarter. I think, today, I think options can be somewhat interesting, but they've gotten more expensive here in the last – since the end of the quarter. How we think about the difference between the rate options and the mortgage options, we feel like – one, it's a cost efficiency. It's just a relative cost on the one hand versus the other, but we do feel like the rate protection is maybe, in some cases, a better – a good insulator on the rate options to lower rate exposure and the mortgage options tend to correlate better up rates and higher. So, we're using both from time to time. The magnitude in which we use that and the proportion in which we use it will depend on the cost of optionality at a given point in time versus fixed-rate hedges. And recently, that's been a little bit less of an emphasis on the option side versus the fixed cost hedge side.

Got you. Okay, that's very helpful. Thank you.

Thank you for your question. [Operator Instructions]. The next question will come from David Walrod with Jones Trading. Please go ahead.

Good morning, everyone. Most of what I had has been taken care of. I guess the only question I have left is, Rock, you mentioned the market pricing in a rate hike here at the end of the year. What are your expectations for the number of rate hikes in 2018?

Well, there's a lot of factors that can play out between here and there, Dave. It will depend a great deal on who that person is in the chair, I suppose, and tax reform could be a significant factor in potential growth inflation expectations and rate levels. So, there's a lot to be laid down on the table here over the next couple of months that will, I suspect, have a pretty meaningful impact on what the actual pace is in 2018. But we are, by definition, taking a view through our pretty substantially hedge position that we want to be protected against one or more than one potential rate rise over the course of 2018 and out in time. If we didn't have a view that there was going to be a pretty significant probability of those – that one or more than one rate hike coming into play in 2018, we would not be probably as hedged as we are at this point. Or we would be shifting the hedge composition to reflect a higher or lower expectation. Market expectations are for one and some reasonable percentage of two next year. If we felt like it was going to be significantly less than that, materially less than that, we would definitely be modifying our hedge position to reflect that. And I think in the third quarter, at least, what you saw was the opposite, which was an increase in the overall hedge notional versus total bond notional in the portfolio.

Okay, thank you very much.

Thank you, Mr. Tonkel. There are no more questions at this time.

Okay. Appreciate it, everybody. If you have further commentary or questions, please give us a call. We'll be available to chat with you when you like. Thanks very much. Appreciate it. Bye.

Thank you, ladies and gentlemen. This concludes today's call and you may now disconnect your lines.