Annaly Capital Management, Inc. (NLY) Q4 2015 Earnings Report, Transcript and Summary

Good morning. And welcome to the Fourth Quarter 2015 Annaly Capital Management Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Ms. Jessica LaScala of Investor Relations. Please go ahead.

Good morning. And welcome to the fourth quarter 2015 earnings call for Annaly Capital Management. Any forward-looking statements made during today’s call are subject to risks and uncertainties, which are outlined in the Risk Factors section in our most recent annual and quarterly SEC filings. Actual events and results may differ materially from these forward-looking statements. We encourage you to read the forward-looking statements disclaimer in our earnings release, in addition to our quarterly and annual filings. Additionally, the content of this conference call may contain time-sensitive information that is accurate only as of the date of this earnings call. We do not undertake and specifically disclaim any obligation to update or revise this information. During this call, we may present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings release. Participants on this morning’s call include: Kevin Keyes, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer, Agency and RMBS; Michael Quinn and Jeffrey Thompson, Co-Heads of Annaly Commercial Real Estate Group; Glenn Votek, Chief Financial Officer; and Tim Coffey, Chief Credit Officer. I’ll now turn the conference over to Kevin Keyes.

Thanks, Jessica. Good morning. And welcome to the Annaly fourth quarter earnings call. On last quarter’s call, I compared and contrasted global macroeconomic conditions and framed certain market movements we had anticipated since the beginning QE3 back in September of 2012. As this quarter’s earnings season comes to an end, the realities of slowing growth and increased market volatility we’ve talked about, continued to persist. The fourth quarter’s negative 4% earnings growth for companies in the S&P 500 marks the worse quarter in over six years. And the VIX index, as one measure of market volatility, has spiked as much as 55% in the first two months of 2016. So, rather than reiterating market themes we talked about and lamenting the ever-challenging investment environment, I’d like to describe in more detail the platform and strategies we’ve put in place on this call, which have Annaly prepared now more than ever to maneuver in these demanding and volatile markets. I’ll begin by further framing our capital allocation and financing strategies over the past 12 months, now more comprehensively defined in our enhanced financial disclosure this quarter. Specifically, in addition to describing the improved and more sophisticated investing and financing approach in our core agency strategies, we have further detailed our three credit businesses: commercial real estate; residential credit; and middle market lending, which we have been managing for years and are now of the size and breadth on our balance sheet that maries this enhanced disclosure. Over the past 12 months with the relative and heightened volatility in the rates markets we anticipated, our allocation of capital into lower-levered floating-rate credit businesses, essentially doubled from 11% to 23% of our total equity capital. During 2015, we invested $1.5 billion by growing our commercial real estate business approximately 25%, launching our own resi credit platform and nearly tripling the size of our middle market lending portfolio. On a standalone basis of roughly $3 billion of equity capital, these three businesses now amount to one of the largest hybrid mortgage REITs overall, and three times the size of the average market cap for the 40 mortgage REITs in the industry. Our strategic plan, which began years ago in diversifying investments in assets with complementary cash flows, also involved the diversification of our financing sources. We have anticipated the impact of regulation and executed on this plan like no other company in our sector. Financing the 20 product strategies across our four main asset classes includes multiple funding options and sources, adding to our capacity for growth while as importantly, insulating us from the obvious risks, monoline strategies faced, especially today. In addition to our broad and diverse repo counterparty relationships, secured warehouse lines and our ability to structure, leverage or securitize parts of our loan portfolios, Annaly maintains the largest available balance in the sector with the FHLB of Des Moines and is benefited from direct repo through our broker dealer RCap Securities, which has been in operations since 2008. While others are now just attempting to establish their own broker dealers, RCap is another good example of a proprietary business we’ve developed over time. And while we’ve not marketed, this part of the franchise provides unique value to our platform. Next, it’s also critical to highlight that while we have made broad investments over the past few years in both our investment and financing strategies I just described, we’ve not asked our shareholders to bear any of the incremental costs for this growth and diversification. As part of our initiatives around enhanced disclosure, we’ve also recently illustrated the operating efficiency of the Annaly hybrid business model, summarizing operating expenses, as a percent of average equity and assets. Following disciplined cost-cutting programs and certain strategic streamlining, we have kept our operating costs significantly lower than the average for the industry, 50% less operating expense as a percentage of equity and 65% less as a percentage of assets, each year since 2012. And when these ratios and other measures are compared against the top 10 largest hybrid REITs in the factor, Annaly’s operating efficiency is even more apparent. In addition to our efforts to maintain superior operating leverage, we have sharpened our focus on improved corporate governance practices. In this year, we will introduce a broad employee stock purchase plan whereby large percentage of our employee base will not be granted stock but rather will be asked to purchase predetermined amounts of shares in the open market, based on certain criteria including seniority, compensation level and role. Establishing more of an ownership culture for the long-term throughout the firm is extremely important to me and is consistent with senior management’s current program, which has resulted in purchases of 1.4 million shares over the past few years, something not done in the sector. Finally, in regards to our outlook for 2016, let’s just say we are not surprised by the macroeconomic headwinds, central bank policy divergence, and certain geopolitical events since the start of the year. Against this increasingly challenging backdrop, the largest and most diversified investment platforms are favored. Our plan is to make the most disciplined, optimal investment decisions based on risk-adjusted relative value and return. We will continue to balance the liquidity of our agency strategies with our lower levered floating-rate credit alternative. We will not just diversify because we can. Our shareholders own us for conservative portfolio management and income. And in the market with limited income alternatives, Annaly’s built as a unique and efficient yield manufacturer with the multiple investment and financing options that allow us to take advantage of current market volatility, expected industry dislocations, and the unforeseen opportunities we’ve been waiting for. Now, I’ll turn the call over to David Finkelstein, who will provide some specific market trends and discuss our agency and resi credit strategies and outlook.

Thank you, Kevin. The fourth quarter proved once again to be a challenging environment for mortgage investors as interest rates increased, yield curve flattened, and MBS exhibited further spread widening. In spite of this volatility, our low leverage and conservative positioning enabled us to generate a modestly positive economic return on a quarter. Prior to discussing our outlook for 2016, which is obviously of great interest to investors given the turbulence that has characterized all financial markets thus far this year, I’ll briefly recap the fourth quarter. I’ll being with residential credit where the more notable activity occurred in our portfolio last quarter as we added just over $500 million in non-agency assets. Residential credit spreads widened modestly in the fourth quarter and have further weakened thus far in 2016. We welcome this spread widening as we view it as primarily technical along with the decline in broader risk assets rather than reflective of the fundamentals of the U.S. housing market. Our credit portfolio is still relatively small which enables us to opportunistically take advantage of cheaper valuations. In other words, recent spread-widening more than compensates for the moderate shift in sentiment regarding the state of the U.S. economy, and housing fundamentals overall remain healthy. As it stands today, while we are certainly respectful of market volatility and elevated risk and liquidity premiums across the board, we do anticipate continuing to grow the residential credit portfolio in 2016. Turning the agency MBS, our position did not change materially over the quarter. We maintained our focus on call protected pools with stable cash flows in the form of both lower loan balances as well as seizing collateral. The continued spread-widening, left agency MBS LIBOR option adjusted spread at the widest levels since 2011. This is somewhat justified, given tighter swap spreads and higher funding costs, both in absolute terms and relative to LIBOR where we saw term repo spreads to LIBOR increased roughly 25% to 50% over the course of 2015. In spite of slightly higher financing cost in today’s market, as Kevin discussed, we believe that our availability of financing is amongst the strongest in the mortgage REIT sector. With respect to hedges, we continue to assess the impact of tighter swap spreads, which we believe will remain inside of historical levels for months to come. As we said on our last call, ultimately our funding remains tied to LIBOR. And while we seek diversification in hedges when opportune, we do not intend to depart from swap hedging in a meaningful way at this point. Now, let’s shift the discussion to the current state of markets and what we expect going forward. As we all know, overseas economic developments have led to erosion in commodity prices, sharply lower interest rates and widespread deterioration in equity and credit markets across the globe. Like most other investors, we anticipate follow-on effects from the global landscape to continue to impact U.S. financial conditions. And as a consequence, we do expect a pause to the policy normalization over the near-term, thus interest rates are likely to remain relatively low across the yield curve. That being said, it is important to distinguish the U.S. economy, which remains sound from the broader global economy, notwithstanding tightening in U.S. financial conditions. In particular, we view the recently much discussed prospects for negative policy rates and extremely lower negative yields out the yield curve as only a remote possibility. We view the U.S. economy and financial markets to be fundamentally different from Europe and Japan and see that Fed is having more arrows for policy easing in its quiver than other major central banks, should conditions warrant. And most importantly, central banks that have recently introduced negative rates had yet to prove their viability in achieving higher inflation rates. The negative rate debate should not distract from the importance placed on the Fed in cautiously carrying out monetary policy in 2016. We expect the Fed to play a very measured approach and as a result, we expect agency spreads to remain relatively stable. Additionally, residential credit fundamentals are supportive of current spread levels. And while we will remain conservatively positioned, we expect a better investment environment going forward than we were faced with in 2015. And now, I’ll hand it over to Mike to discuss the commercial business.

Thanks David. The fundamentals of the U.S. commercial real estate market remain strong. We’re seeing a growing dislocation between current property performance and the performance of the publicly traded capital markets. In the fourth quarter of 2015, CMBS spreads continued a widening trend that started in the summer and in 2015 both AAAs and triple BBBs have reached their widest levels since the last crisis. In addition, equity REIT share prices are also total of about 15% from peak levels reached in early 2015. We believe this is attributable to a combination of factors including one, a liquidity driven decline in a broader market that is shedding risk; and two, the market predicting slowing growth and a decline in fundamentals. 2015 saw volumes reach post-crisis record levels with 533 billion of property sales, up 23% over 2014 and 101 billion of CMBS issuance, up 7.5% over 2014. However, while previously announced deals continue to close, newly announced transactions have finally slowed considerably in the past three months as the volatility in the credit markets has disrupted acquisition activity. At this point, the pricing trend continues to be flat at historically low cap rate levels but as the path of any guide, the slowdown in activity does not bode well for sellers. Despite these challenges in the public markets, we still see significant investor demand for real estate in the private market with long-term sovereign yields at low levels including a sub 2% 10-year treasury. Global investors continue to look to U.S. real estate for yield and capital preservation. Although credit standards have tightened and spreads are moving wider, high -quality borrowers with good assets and good markets will still attract capital. As of the end of 2015, our commercial real estate portfolio stood at $2.5 billion. Net of leverage and one senior loan held for sale, our net economic capital invested in commercial real estate was $1.5 billion and is producing a leveraged yield of 9.1%. In addition, we’re very comfortable with the performance of the assets in our existing portfolio. Borrowers have been achieving business plans often ahead of schedule and have taken advantage of growing cash flows and strong capital markets to pay off our loans. For example, excluding sales of senior loans, since the beginning of 2015, we have received over $900 million in loan payoffs. Our current portfolio’s diversified by geography, sponsor, and asset class. We remain concentrated in the office and multi-family sectors, which combined make up 68% of our portfolio are less exposed to the hotel sector, which makes up only 6% of our portfolio, and have no exposure to land or for sale condominiums. At Annaly, we continue our cautious approach to new business that we have had in place for over a year. As we’ve discussed on the past two conference calls, we have moved the business towards more of an institutional model, focused on larger transactions with the highest quality sponsors and are no longer focused on flow business that requires securitization access to be profitable. With the strength of our capital position and the depth of our institutional relationships, we believe we are well positioned to take advantage of current and future volatility. We are focused on attractive risk-adjusted returns on our investments and are able to participate across the capital stack, further enhancing our portfolio flexibility. However, given the diversity of the Annaly platform and its range of investment options, we have never been focused on volume. Our commercial real estate portfolio will only grow if we see great opportunities. Preservation of capital is our priority while we provide our shareholders with longer term, primarily floating-rate cash flows as a strategic complement to our agency portfolio. And with that I’d like to turn it over to Glenn to discuss our financial results.

Thanks Mike and good morning everyone. As Kevin mentioned, we continue to enhance our financial disclosure, consistent with the expansion of our credit businesses, which is intended to provide a greater level of transparency in terms of both composition as well as performance of those businesses. For example, this quarter, we added financing and leverage profile to our business line; we also provide additional detail on our various financing sources including rates [ph] and maturity profiles. As well, we continue to include in our discussion of our financial performance both core and normalized core results in addition to our GAAP figures, which while not a replacement for GAAP, are intended to provide useful supplemental information to assist you in better understanding the performance of the business. So with that, beginning with our GAAP results, we reported net income of just under $670 million in the quarter or $0.69 a share that compares to Q3 net loss of just under $628 million or $0.68 a share. The favorable quarterly change was largely attributable to unrealized market value changes on interest rate swaps. Our core earnings increased sequentially to $0.33 a share that compares to $0.21 a share in the prior quarter. Changes in estimated long-term CPR impacted both quarters through premium amortization expense. The Q4 reported premium amortization was $160 million and that compares to $255 million for the third quarter. This was due to a decline in projected long-term CPRs to 8.8% in comparison to 9.2% in prior quarter. The component of premium amortization due to the change in estimated long-term CPR resulted in benefit in the quarter of $18 million compared to a cost in Q3 of $83 million. Our normalized core earnings which are adjusted for this component of premium amortization, was $311 million or $0.31 a share versus normalized core earnings the prior quarter of $0.30 a share. The primary factors contributing to the sequential improvement in normalized core were a higher combination of -- were a combination of both higher coupon income within the agency portfolio as well as higher income from the commercial investment portfolio, partially offset by a higher repo funding cost, all of which contributed to improvements in both normalized net interest margin, net interest spreads as well as our normalized core ROE, which was 10.3% for the fourth quarter compared to 9.7% the prior quarter. Consistent with Kevin’s remarks concerning operating leverage and focus around operating efficiencies, we consistently maintain a focus on both scale and efficient of our operating platform and our overall expense structure. Total operating expenses in the quarter were $47.8 million, which was down about 3% sequentially. In terms of our balance sheet, investment securities were up modestly to $67.2 billion, that includes approximately $1.4 billion of agency CRTs and non-agency MBS, which as David mentioned earlier, grew over $500 million in the quarter. Our commercial investment portfolio declined slightly due to reduction of assets held for sale following completion of a recent syndication. And as Kevin mentioned, the combined credit investment portfolio now represents 23% of our capital. Book value declined to $11.73 a share, leverage as traditionally reported was 5.1 times and economic leverage we ended the year at 6 times. And lastly, during the quarter, we began repurchasing shares under our previously announced $1 billion share repurchase program. To-date, we have purchased 23.1 million shares, totaling $217 million at an average price of $9.40 a share, of which 11.9 million shares totaling $114.3 million settled in the fourth quarter. So, with that, Nan, we’re ready to open up to questions.

Thank you. [Operator Instructions] Our first question comes from Douglas Harter of Credit Suisse. Please go ahead.

Hi. This is Actually Same Sam Choe filling in. So, I was just interested in hearing about where you see the best opportunities for risk-adjusted returns. And maybe on a related note, how do you see leverage trending this year?

Hi, Sam, it’s Kevin. I’ll give you the bigger picture and then I’ll let David and Mike and the rest of the team fill in the gaps. I mean I think the good position that we’re in is that we’re not a monoline. And we have, as I mentioned in my prepared comments, a diversified strategy. The four businesses are agency, resi credit, commercial, and middle market lending. And I think I’d say a couple of things. First, how we prioritize is really done on a daily basis in terms of the market and in terms of the supply and in terms of valuations. And in this marketplace, given the volatility, when I say daily, that’s not exaggerating. So, I think the beauty of it is, is we have multiple options. If you want to corner me today and have me forced rank those options, I think it’s been demonstrated over the past couple of quarters that we think there is value in shifting into certain types of credit at certain times, given the nature of the cash flows and the lower leverage profile. And by the way, these businesses tend to protect book value quite well amidst this volatility. I think resi credit obviously grew the most last year. I think our outlook is that it will grow this year but not at the same pace. Obviously, we’re going to be starting from a bigger base in terms of capital. Middle market lending is a business we’ve had here since 2009 and we haven’t talked much about it. It’s been a patient grower, very similar to some other things that we’ve done here over the past. That business will grow consistently just based on what’s happening in the marketplace with other participants that by definition, the competition’s kind of coming to us. Commercial real estate, you heard Michael’s comment, we’ve grown that business nicely. We have really a strategy that’s institutional rather than retail. And the definition of institutional business is it tends to be larger, higher profile; and by definition, if you ask me, more higher quality. So, I kind of mention them in that order because I think that’s probably the order of growth, if we were sitting here today. But that being said, the agency business, as our core is always going to be our core. And the liquidity of that strategy and the government backed nature of those assets and those cash flows, we have to make sure we get a very good premium to that return in order to participate in Annaly’s credit strategies. So, I’d summarize it that way. It’s really -- I think the resi credit, middle market lending grew last year and they will continue to grow. Commercial will be relatively lumpy to those two businesses. But overall, these businesses have to compete with the agency strategies, which in this market have got a little bit more attractive than they were certainly in the fourth quarter.

Okay, thanks. That was really helpful. I got just one more. So, when you’re talking about your funding position and talking about the flexibility, you mentioned RCap. And, I was just wondering, I mean, because there has been a lot of talk within the industry about alternative financing sources. And just wondering how long it takes normally for a REIT to get that -- the broker dealer sub fully operational and what kind of first mover advantage does that offer for you guys?

I’m not going to comment on how long it takes people to do it. We have reestablished the broker dealer, like I said 2008. And it takes a lot of work; it takes a lot of expertise; it takes infrastructure, systems, legal, technology. So, I think in terms of a first mover advantage, I mean we’ve had it for eight years or so. So, I don’t know if that’s first mover or not, but that is decent period of time. I think we haven’t talked much about it, because it’s one of our many sources of financing. Part of the strategy to diversify frankly into complementary assets was, there is complementary financing out here from our relationships. And so, you can’t do one without the other. And I think RCap is -- it’s a critical element that -- put it this way, we are glad we’ve had it in place as long as we have.

Your next question will come from Bose George of KBW. Please go ahead.

Hi, good morning guys. It’s Eric [ph] on for Bose. How do you think about taking realized gains in certain areas of the portfolio as rotate into new strategies?

That’s a good question. When we think about accounting consequences of shifting the portfolio, we want to -- we generally want to preserve the yield in the portfolio. So, we try not to take gains when we do shift, simply because we want to preserve the yield. But nonetheless, if the economics suggest we do so, we absolutely will, but it’s the consideration nonetheless.

Okay, alright. That’s really helpful. Thanks. And is it your intention to run with the smaller hedge portfolio, as you transition into new strategies? And if so, do you think that would be -- you’d save anything on your swap expense?

You’re saying reduce the hedge position…

Right.

…given the diversification? It does go hand in hand. And to some extent, you can argue that some of the credit positions actually do act as a rate hedge. We also have a rather large IO portfolio, which has negative duration and positive yield. And to the extent that sector cheapens up, that’s an alternative to reducing the hedges. But our hedge position’s been relatively stable for the past year and there is no immediate plan to reduce that particularly given where rates are currently.

Our next question comes from Joel Houck of Wells Fargo. Please go ahead.

Thank you. Just to stay on that hedge theme for a second. So, what you’re saying is there haven’t been changes yet, theoretically there could be. But it sounds like, I don’t want to put words into your mouth, it sounds like given how low rates are right now, you’re kind of hesitant to lower the hedge in the agency book, even though conceptually, because your diversification strategy has played out, you still want to be cautious. Is that the thinking right now?

Yes. This is David, Joel. That’s a good way to think about it. In the current environment, we want to maintain enough duration in the portfolio, if the market should further rally, but not too much duration to where we won’t be in good shape for or in the event of a selloff. So, we’re very cautious with respect to rates here. And we’re playing it down the middle on that front. And we’ll look for alternative hedges, should the environment suggest we do so.

Okay. And then the follow-up, I mean if we saw better growth prospects out of U.S. and presumably higher rates, would that the kind of what you’re looking for to perhaps reduce the hedge on the agency book?

Yes, potentially and higher rates would naturally extend our duration. We were comfortable with where our duration profile was at the end of the year, which was a little over a year. And as rates have rallied, the mortgage markets contracted, and we’re still about half a year and so, some of that would come through extension of the portfolio. But there is certainly a level where we would take more rate risk, absolutely.

Okay. And lastly, given your comments about, I guess lower leverage on the non-agency stuff, is it -- does it make sense that as credit spreads and the overall health of the capital markets and liquidity improve that you would look to take leverage up and therefore the returns that you’re seeing in non-agency right now are kind of comparable to agency but they could be higher, it’s not something that you want to lever in this type of environment. Is that a fair characterization?

No. I would say we don’t have to lever as much in the non-agency space, currently. If you just take credit risk transfer for example where the most recent deal price, which show on the second last piece for the low LTV bucket with 675 basis points, you can fund that as about LIBOR plus 165, 175. One turn of leverage gets you to double digit returns. So, given where credit spreads are at, you’re not -- it’s not -- it’s necessary to take as much leverage. Now, should the fundamentals change, spreads tighten, and we’re much more comfortable, we’ll certainly add leverage to that business and also capital.

Joule, it’s Kevin. I think, the one thing I would add is just take a step back among all the credit businesses now that they’re of obviously more scale, this time versus where they were at this time last year. Our plan is to obviously optimize the capital and have incremental structural leverage put on, on these businesses that wasn’t there because we didn’t have the size. So, you’ll see, if we do our job, we’ll have more efficient use of our capital with underlying leverage in these businesses in any growth scenario going forward this year.

Our next question comes from Brock Vandervliet of Nomura. Please go ahead.

I’ve seen a huge amount of volatility just since December, one item is obviously the flattening of the curve -- going from 120 to about 100 today. How should we think about your normalized spread dynamics looking forward over the near term?

Hi, Brock, this is David. Also as the market’s rallying and the curve has flattened, agency spreads have widened a little bit. And I would think about it, currently in agencies yields up 280 to 285 or thereabouts, the hedge and financing costs are about 150 to 160 and you apply six times leverage to that and can still get low double digit returns in terms of absolute returns and spread.

Okay. Just as a follow-up, it appeared to us the third quarter normalized net interest spread was somewhat different than you showed in the current release. Was there a re-class or anything from the third quarter to the fourth?

No.

Okay, thanks. I’ll follow up offline.

This concludes our question-and-answer session. I’d now like to turn the conference back to Mr. Kevin Keyes for closing remarks.

Thanks everyone for dialing in this morning and your interest in Annaly. And we will talk to you next quarter. Thanks.