Annaly Capital Management, Inc. (NLY) Q3 2017 Earnings Report, Transcript and Summary

Good day, everyone and welcome to the Annaly Capital Management Third Quarter 2017 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 do note that today's event is being recorded. I would now like to turn the conference over to Jessica LaScala of Investor Relations. Please go ahead.

Good morning and welcome to the third quarter 2017 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 the 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. Please also note this event is being recorded. Participants on this morning’s call include Kevin Keyes, Chief Executive Officer and President; David Finkelstein, Chief Investment Officer; Glenn Votek, Chief Financial Officer; Tim Coffey, Chief Credit Officer and Michael Quinn, Head of Annaly Commercial Real Estate Group. I will now turn the conference over to Kevin Keyes.

Good morning, everyone. Any way you look at it, most asset prices in markets are overvalued relative to historical metrics, which is especially disconcerting in a market that hasn’t been this calm, or should I say complacently smog since the year 1928. So many obvious headlines to site like the Dow's current 250-day streak without a 3% correction the longest in 22 years and Nikkei's recent all-time best record for days of consecutive games, corporate high-yield trading at 63% premium to its average since the year 2000 and the U.S. equity markets PE evaluation at a level we've seen less than 1% of the time historically are all signs that point to risk assets looking pretty risky. More significantly and currently ignored by many is the fact that the relative value of risk assets versus lower risk assets appears even more highly imbalanced. For instance, the difference between the U.S. 10-year treasury yield in the S&P 500 yield is tighter now than any other developed market worldwide, a spread that is only traded more expensively a few times since 2005 and while risk markets attempt to defend these unsustainable valuation levels, volatility remains an all-time lows as measured by its Sharpe ratio and assets returned relative to its volatility but Dow would have to gain more than 70% over the next 12 months to match it's 32% return over the past year, which was delivered at a realized volatility level of 7%, which is less than half the historical average level of all since the year 1900. Markets have always proven that low volatility does not translate to low risk in perpetuity and that risk asset optimism can only be sustainable for so long. Something has got to give in this market. For Annaly, against this current backdrop of highly valued high risk, we successfully maintained our consistently by growing our book value and delivering another stable dividend of $0.30 per share for the 16th consecutive quarter. In addition, since the start of the third quarter in three successful transactions, we attracted over $2.4 billion in growth capital, the most primary proceeds raised in overnight offering by any U.S. company this year. The significant market demand for these offerings from both new and current investors is proof that certain buyers in the market appreciate our relative value proposition in this frenzied world and the transaction serve as a clear endorsement of the successful execution of our diversified strategy and outperformance in recent years. An important distinction must also be made in comparing our capital raises to other stock issuances in the broader market. As further evidence of an equity market, which is more than fully valued unlike our offerings, which raise capital for investment, nearly 70% of all similarly-sized overnight equity offerings recently executed are made up of at least 50% secondary shares, with management teams in-fighters, Board of directors and financial sponsors casting out of their positions. While others are selling into this market overvalued bid and taking their own money off the table, we are doing the opposite and investing alongside our shareholders. In addition to raising this accretive capital earlier this past quarter, every member of Annaly's senior management team including myself, committed to increase their own voluntary stock ownership over the next three years. I think I'm destined to reiterate this on every call, unlike all others, we are buying our company's equity. We're not being granted stock and then selling it back into the market. Prior to immediately following our capital raises, we efficiently invested primarily in agency MBS as the agency asset class looked attractive both on an absolute basis and also relative to credit. Following our July offerings through our most recent deal in October, agency spreads tightened modestly while the pace of spring training has begun to moderate in certain credit sectors and whole owned markets remain attractive. Given the fundamental valuation issues in these various credit markets, we have been measured about our participation in most sectors throughout the year and yet we are still originating attractive opportunities especially in our middle market lending and resi credit platforms, which continue to grow. Our shared capital model is based on direct origination with premier financial sponsors and proprietary asset sourcing partnerships with the largest money center banks and non-bank lenders that will only partner with us in the REIT world. Through these relationships we source and invest in credit differently. We are not bidding blindly in the secondary market and are able to influence structure, thereby enhancing our returns and protecting our downside. For example, in middle-market lending, the number of covenant-like deals in the broadly syndicated institutional market is up over 80% since 2011. Despite this increase in market dynamics through our sponsor relationship we're able to access more defined attractive niche in the industry in which there are 30% fewer [covey] light transaction than the over-picked broadly syndicated market. Within the resident residential credit industry, underwriting standards continue to be quite stringent for GSEs and banks evidenced by the fact that the average GSE purchase FICO at the end of 2016 was 755, which has declined only 1% in the past five years and mortgage delinquencies are at the lowest levels post crisis. And we are taking advantage of these strong housing fundamentals in the narrow credit box created by the regulatory environment and our whole loan portfolio. Our average borrow has a FICO over 750 and the average original LTV is 67%, which is obviously even lower today given the appreciation of home prices. In 2017 we have selectively purchased nearly $2 billion of assets within our residential credit in middle market businesses, while not sacrificing credit quality to achieve double-digit, lower level floating rate returns complementary to our agency strategies. As the third quarter earnings season has commenced for our sector, the conversation continues to censor solely around three isolated variables; leverage, spreads and expense ratios. With our diversified shared capital model, we have a lot more to talk about and have demonstrated many more additional ways to protect book value and deliver superior risk-adjusted returns across our four main businesses. Our company size is 20 times of a median REIT, currently maintains a liquidity position of over $9 billion of unencumbered assets, offers diverse cash flows at 50% less operating cost based on our percentage of equity and has proven to be a successful industry consolidator. We are selective asset manager with superior risk controls. As an operating company, we do not compare ourselves to an ETF, nor chase the risk of an undercapitalized, less liquid single strategy model. As an additional arguably more meaningful measure of our efficiency, we also analyze our operating expenses as a percentage of our consolidated core earnings using this ratio, which is a direct measure of the efficiency of dividend production to our shareholders, our expense ratio is superior to our monoline agency peer set and over 25% more efficient than a hypothetical market peer with a similarly weighted diversified profile. Lastly, when analyzing operating models and costs, it's also critical to ascertain relative performance tied to compensation metrics and in certain instances, quantify and track the additional realized and ongoing costs borne by the REIT shareholder associated in the formation of an operating entity. Finally, as I've addressed on previous calls, we take a more holistic and comprehensive approach to valuation and simply looking at the impact of one metric. We combine traditional academic and market methods to consider different ways to quantify the relative value of both our investment decisions and the associated value of our platforms. In addition to margins, scale, liquidity and operating efficiencies, we consider the sum of the parts of our four main businesses. The concept of alpha premium based on a relative total economic return, comparable sharp ratios and industry leader multiples, which historically tend to be 30% to 40% premiums in any particular sector. Annaly is humbly proud to be an industry leader and has demonstrated outperformance among all options in the equity market, not just among the mortgage REIT sector, our high margin, low beta, liquid diversified and stable cash flow engine remains undervalued, especially in this real global capital market landscape that is currently overwhelmed by momentum investing. Now I'll turn it over to David Finkelstein to expand upon our investment activity.

Thank you, Kevin. The third quarter exhibited range-bound interest rates, strong performance of the agency MBS sector and a moderation of the credit spread tightening that is characterized much of 2017. Our portfolio activity in the quarter was focused on deploying the capital from our common and preferred equity raises and as Kevin mentioned, the vast majority of our new investments occurred in the agency sector. While our capital allocation shows an increase in credit quarter-over-quarter this is largely attributable to near-term financing optimization, primarily less leverage applied to residential credit. Overall portfolio leverage was up modestly, partly attributable to the anticipation of our October equity raised as a significant portion of our additions were purchased prior to quarter end. But as we discussed last quarter, we are comfortable operating in modestly higher agency leverage given the subdued interest rate volatility in the current environment. Specifically, with respect to our agency purchases we had nearly $20 billion in assets, almost exclusively in 30-year pools in TVAs. These purchases were hedged with a combination of swaps, futures and also swaptions, given current pricing of implied volatility, which has reached cycle lows. We also purchased nearly 0.5 billion of agency multifamily dust securities in the quarter. This is another reflection of diversification within our agency portfolio as dust securities exhibit little to no negative convexity and we expect to continue to engage in the sector as relative value opportunities arise. Our holdings of shorter duration agency assets were modestly lower over the quarter, which is primarily attributable to passive runoff in our arms position. I wanted to note that in spite of the decline in our arms portfolio, which is down over $3.5 billion year-to-date our euro-dollars futures position, which is primarily used to hedge the financing of those shorter duration assets is up over 15%. As we previously discussed, we view our short-dated hedges in term repo as interchangeable tools in navigating the front end of the yield curve in financing environment, which we consider liquid. Shifting to our credit businesses, as Kevin discussed, the broad demand for credit assets and current pricing necessitates an even more surgical approach to investing in these sectors. Consequently, we choose to compete in areas where we have a distinct advantage such as our cost of capital and unique partnerships. In the residential sector whole loans continue to be the area of growth for us and while we're comfortable with housing fundamentals, we have opted to reduce our holdings this year in the securitized residential market such as GSE credit risk transfer where newer entrants have supported considerable spread tightening. That being said, relative volatility of CRT pricing do provide trading opportunities from time to time allowing us to maintain a consistent footprint in that sector. Our growth in the middle market lending portfolio came across the deal size spectrum, but it should be noted that we are seeing an increase in opportunities of larger deal size for middle market companies as our sponsor relationships continue to recognize the overall liquidity of Annaly and our ability to underwrite and manage larger deals relative to many others competing in the sector. With respect to our commercial lending portfolio, given the environment in which we grew the vast majority of the portfolio, we continue to face reinvestment risk. However, we maintained the size of that portfolio in spite of roughly 10% run off, but as we've stressed repeatedly, we will not sacrifice credit and deal quality simply for the sake of portfolio growth. And lastly, regarding our outlook we are comfortable with the current interest rate environment, particularly insofar as the extension profile of our MBS portfolio is very favorable. Nonetheless we will continue to actively manage our rate exposure as markets adjust as we've demonstrated in the past. In credit our model allows us to be patient and focus on the unique advantages of our credit businesses as we discussed and we anticipate better entry points and broader credit markets out the horizon. We'll maintain a conservative approach with respect to leverage and the financing of our assets, particularly when it comes to the quality and diversity of our lending counterparties. And with that, I will hand it over to Glenn to discuss the financials.

Thanks David. Our financial results once again highlight the Annaly franchise and its ability to generate consistent financial performance. So, beginning with our GAAP result, we reported net income of $367 million or $0.31 a share. Among the factors driving the results were increased net interest income, improved market interest rate swaps and gains on trading assets. In terms of core earnings, we posted $354 million of core earnings excluding PAA or $0.30 share. So PAA for the quarter was approximately $0.04. Comparable second quarter core earnings excluding PAAs of $333 million or $0.30 a share for a PAA cost of $0.07. Some key factors contributing to the comparative quarterly results were coupon income, driven by both larger portfolio balances and slightly higher average rates as well as higher dollar roll income that combined, represented an increase of about $0.03. Offsetting these increases were higher interest expense, for both balances and cost rose for the quarter, which was partially offset by lower net swap expense and together represented higher economic interest cost of about $0.02. Additionally, approved dividends on preferred shares increased about a $0.01 primarily due to the recent series issuance. As Kevin mentioned, we declared a common stock dividend of $0.30 per share, marking the 16th consecutive quarter of payout level and of note we also included in our core earnings per share computation cumulative and undeclared dividends of $8.3 million and a recently issued Series F preferred stock. The Series F dividends were not declared during the third quarter, so they were not reported on the balance sheet as reduction in equity as that preferred stock contained a first long dividend period and is scheduled to be declared payable on or about December 31. For the full long period, dividend will reduce book value in Q4, which is when we would expect that dividend to be declared. Our financial metrics remained strong with core ROE excluding PAA of approximately 10.6% and our comparable net interest margin was 147 basis points, net interest spread 115 basis points. Operating efficiency metrics were stable in the quarter with OpEx-to-assets at about 25 basis points, OpEx-to-equity at 170 basis points. Book value increased 2% to $11.42 and economic leverage ended the period at 6.9 times and during the quarter we successfully raised approximately $1.5 billion of equity capital through a combination of common and preferred equity offerings. The capital raise of the previous book value contributed the balance sheet growth of approximately $12 billion, the increase largely coming from the agency portfolio and combined with TBA purchase contracts, the aggregate investment portfolio ended the quarter, up $19 billion. Originations and new investments across our credit platform were solid representing over $500 million a quarter with a net growth somewhat tempered by paydowns. From a capital allocation standpoint as David had mentioned, credit portfolio represented 23% of allocated capital at the end of the quarter. And finally, during the quarter, we completed the repayment of our Series A preferred, which when coupled with the Series F issuance, reduces the economic cost of our outstanding preferreds by 30 basis points and we also completed the previously announced sale of our mortgage servicing business. And with that William, we're ready to open it up to questions.

Thank you. we'll now begin the question-and-answer session. [Operator instructions] And it looks like our first question will be Rick Shane with JPMorgan. Please go ahead.

Hi, thanks for taking my questions. Two things, one towards the end of the third quarter, we did see some spread tightening in the agency space, when you look at relative opportunities within your different business units, did that change the outlook at all this point or are you still is that the place you want to deploy capital?

Hey Rick. Well it's kind of consistent with the past couple years where we have these episodic opportunities in different parts of the cycle within either a quarter or a month or two. I would say yes and yes, we just raised a bunch of capital predominantly because of the relative value in the agency asset that we can procure and with the recent uptick in valuations layer, something have loosened up as I mentioned in my prepared remarks in our credit businesses primarily in Resi and middle market lending. So, the easiest answer for that I think you've heard me talk about it is we have this shared capital model which is really an accordion that reflects in and out on literally a daily basis. So, we're seeing pockets sometimes the credit lead time is obviously longer than the liquid business that we do on the agency -- on the agency platform. But I think going forward, our credit backlog is actually larger without sacrificing quality in terms of dollar amounts and number of deals than it has been in the past couple of quarters and there's a macro comment we've made before that we think the stimulus -- removal of stimulus has impacted the interest-rate markets and have yet to really impact the credit market. So, we think when that happens and it's sure to happen there will be even more opportunity within our credit businesses. So long story short, I think we're more liquid today than we were on the last call, not just because of the capital raises. When David looks around to Mike Quinn or Tim Coffey in their businesses, it's all relative value measurement and I think we really do what we literally do a deal-by-deal, asset-by-asset relative value, risk adjusted comparison and the best -- the best return on that basis wins. So, going forward I would think our balance now is 23% credit, everything is expensive to my comments, agency is frankly less expensive and easier to hedge more liquid. So that's why we put that money to work the past couple months, but like I said going forward we could flex into more credit. We're just waiting for that and the valuation to adjust.

I was going to say, the velocity with which you can access and deploy capital is pretty unique.

Yeah, I think that's why I am really comparable to the sector, we're a self-financed diversify manager. So, we don't have to wait or to rely upon outside sources to transact and with our paydowns that we've talked about $800 million to $1 billion a month, that cash flows in a market that -- that's we are waiting and appreciating more volatility as that's when we can use that liquidity and take advantage more than most any other financial company our size.

Okay. And specific question, do you guys still have any exposure to 111 less 57?

No.

Thank you.

Thanks Rick.

And our next question or two will be Douglas Harter with Credit Suisse. Please go ahead.

Thanks. I was just wondering your thoughts hearing what you're saying about the complacency of the markets, how you're trading off kind of current return while those returns -- the markets might stay complacent for a while versus preparing yourself for the eventuality of return of volatility and how you're viewing that risk trade-off today?

Well for -- hi Doug. For four years in a row now, 16 quarters we've paying like 10%, 12% quarter-after-quarter with less leverage and more diversity and more liquidity while buying a company to pick up capital assets and earnings, raising capital to do the same. So, I think and there is only really been two volatile quarters in the last six and that's when we've bought a company or grew our credit businesses. So how I look at it now as we're in this earning season and my commentary is I think is meant to be constructive that I think the market's valuations have contracted here a bit because the market figures if you're monoline agency REIT and your cost of financing is increasing and the only tool you have to generate or manufacture earnings is more leverage, the quality of those earnings by definition are more risky, so that valuation should reflect that. Now of course we're in those asset classes, but we're also in three other large markets that are fragmented and in need of permanent capital. So, I think the valuation contraction is tied to a lot of uncertainty that's not reflected in the equity market in terms of what's going on in the other parts of the world and central banks and macro economies. But I think long story short, I think we're going to continue to just produce the state -- the stability of our return, which overwhelms the rest of any one of our mortgage REIT peers. There's been 80% of the sector has cut their dividend over the time that we have not and we protected book twice as better three times as better as anyone else. So past performance should -- does not necessarily indicate future results but year after year with this diversified model that's why we pointed four years ago, we have been able to stable earnings and protect book better than anybody and in the volatile times is when we frankly get more aggressive

It makes sense. Thank you.

And our next question or two comes will be Bose George with KBW. Please go ahead.

Good morning. Can you talk about returns in the agency market now versus a couple months ago and then just compare the differential between your returns and agencies versus your various credit buckets?

Sure Bose, this is David. Returns on agencies right now on a levered basis to eight times leverage or just over 10%. With respect to credit, the areas we're operating in primarily in residential whole loans as well as in the middle market space has obviously lower leverage, but returns probably just north of 10% in certain cases in the resi space and right around 10% I would say in the middle market space. So, returns are similar, but you're obviously operating with different risks and different leverage levels and we hope over the longer term we'll be able to rotate more into those sectors, but for the time being, agency serves as the liquidity engine in the deployment of capital.

Okay. Thanks, and then in terms of other areas you could deploy into, are there other markets you guys are considering and then in that note, can you just discuss the JV with capital impact partners?

Sure Bose, we're obviously actively involved in across markets, for example, this last quarter moving in dust sector when that sector was probably about 10 to 12 basis points cheaper is simply one example of that. And I think if you look at all of our businesses in the agency space, we're in virtually every sector of the market, more diversified than any of the monoline REITs in our view and then in Resi credit for example from whole loans to legacy CRT and some of the more esoteric assets we're obviously fairly broad in our approach there. And we constantly look at new opportunities in that market a lot of those entail operating businesses, which we've not opted to go into and what we found is that finding partners as we've stressed and discussed in the past is a much more efficient way to acquire assets and so our view is that we'll look at anything that that allows us to acquire assets that have good risk adjusted returns, that don't require a fair amount of operating risks and costs associated with those. And so, we have very large teams in those spaces and constantly evaluate everything and then on the commercial side I can hand it over to Mike to talk about.

On the commercial side, we have a full suite of products that we invest in as well from AAA rated CMBS through whole loans, through mezzanine, through equity. Were constantly evaluating the relative attractiveness of each of those investment opportunities and I think in the current portfolio what we've been seeing the best opportunities in is in the whole loan space. And I think it's limited relative to the opportunities in our other businesses, but we do still find the whole loan business is an attractive place to deploy capital.

And then Bose your question regarding our impact investment that we announced yesterday, it is a relatively small investment, but nonetheless it's something we're very happy about. It gives us the opportunity to invest with a company that is as Kevin said, this press release best in class, a premier lender in that space. The assets are ranged from co-op housing to charter schools to healthcare. The return, it's an unlevered return. We're not at liberty to disclose it, but it's certainly competitive on an unlevered basis with the rest of our businesses and it's something that we hope to explore further.

Okay. Great. Thanks a lot.

And the next question will be Ken Bruce with Bank of America/Merrill Lynch. Please go ahead.

Thanks. Good morning, everyone. I have a couple company-specific questions and then a bigger picture question. I am trying to reconcile some of the comments around the complacency in the market and I guess what looks to be an increase in economic leverage, is that just purely a shift into agencies that's driving that or are you just willing to take more leverage against the agency portfolio as I think David had pointed out there is just recent volatility being still low you just kind of have to take a little bit more leverage to get paid?

Yeah Ken this is David. I'll address the leverage question first. At quarter end our leverage was 6.9 times and as I said in my prepared comments, we did acquire a fair amount of the assets that we anticipated raising equity to support and so it was somewhat elevated right at quarter end. I think that if you took the equity, we subsequently raised in the following week in the assets added, our leverage would have been 6.75 times. So just up a little bit from 6.4 times. Our view is that and as we've said is that the interest rate environment has been somewhat benign in terms of rate fluctuations, which has decreased the cost associated with hedging our mortgage portfolio both dynamically and also, we've added a fair amount of swaptions of $4 billion at quarter end then about another $2 billion subsequent to that. The convexity profile of the mortgage -- of the mortgage portfolios is good as it's been over the past couple of years, which is something that makes us more comfortable adding leverage to. And one last point with respect to valuations and this follows up on Rick's question earlier, valuations did raise in September but it's important to note that we were coming off a very inexpensive valuations in July or thereabouts and so right now the market is relatively fair. It's not priced to a point where we would add leverage from here, but we're certainly comfortable at around six and three quarters to seven times leverage with the current market environment.

My comment Ken on being complacent is the equity market and the momentum and every day is a new high with the valuation multiples that go along with and without the growth behind it, certainly not on a one-to-one basis because it just makes our business look obviously even less expensive. And that was the thesis that we raised a lot of money around that and we have a lot of different levers to pull as we've been talking about.

And just if there's any rationale or color around -- just I noticed the weighted average days of maturity on the repo agreements dropped pretty significantly and has been, is there any -- is that just -- is there a preference for using shorter dated repo in today's market and just swapping it out or is that -- is there anything to can interpret from that progression?

Sure Ken this is David again, and yes as I talked about in the prepared comments we have a look more towards the euro dollars market to hedge their very short term rate risk and that does have to do partially with our level of comfort and financing markets right now which are relatively liquid, but also when the Fed is raising rates and counterparties are pricing longer term repo contracts a little bit more conservatively to reflect probably a greater likelihood of a rate hike over the near-term than the euro dollars markets are pricing in. So, it's a more efficient trade to actually hedge shorter-term financing rates with euro dollars than term repo and we will continue to do that but we're also going to be conservative with respect to making sure that our repo is there and is readily finally available.

Okay. Thanks. And in my broader question is that there is still this ongoing debate as to what to do with the GC's as it relates to the cash sweep in capitalization and like and I'm interested in if you have a view into this from the perspective of how it impacts either the underlying agency MBS or if it has any knock-on effects that you're focused on?

No. I think it's more of the same. Were in the room in DC and we've spent a lot of time there in terms of the different potential reform. I would say that related to your question is Chairman [Hans] decision not to run or seek reelection to us signal that there could be more beneficial change around the edges certainly around potentially legislature around the FHLB membership and some of the housing finance reform where he had a fairly pointed view on the right side of the page. So, I think how the overall GSE restructuring happens we've been saying GSE reform has already taken place with our legislation in the form of these risk-sharing deals, which we're not only participating in or helping I think to move the market in or educate the market in and providing liquidity to the market. So, it's really more of the same. I don't think I'm looking around the room here if anyone has any additional comments, but as we talk to the investor world, as you do, how that happens or when that happens it's kick the can down the road and in the meantime, it's business as usual in terms of the redistribution of the assets out of the GSEs in the form of risk sharing.

Right. And maybe just an opportunity for politicians to be shrill about certain things with obviously the housing part of the food chain is pushed and pointed to or is alarmed about lack of capitalization. So, I was wondering if there's anything on the back end that you guys focus on and it doesn't sound like there is. So, thank you very much for your comments.

Thanks Ken.

And this will conclude our question-and-answer session. I'd like to turn the conference back over to Kevin Keyes for any closing remarks.

Thanks everyone for your interest in Annaly and we will speak to everyone very soon.