Annaly Capital Management Inc (NLY) 2015 Q4 法說會逐字稿

Good morning. 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 Mrs. 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 the 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 contents 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's Commercial Real Estate Group; Glenn Votek, Chief Financial Officer; and Tim Coffey, Chief Credit Officer. I will now turn conference over to Kevin Keyes.

Thanks, Jessica. Good morning and welcome to the Annaly fourth quarter earnings call. Our last quarter's call I compared and contrasted global macro economic conditions and framed certain market movements we had anticipated since the beginning of Q E-3 back in September of 2012. As this quarter's earning season comes to an end the realities of slowing growth and increased market volatility we talked about continued to persist.

The fourth quarter's negative 4% earnings growth for companies in the S&P 500 marks the worst quarter in over six years. And the VIX index is one measure of market volatility spiked as much as 55% in the first two months of 2016. Surroundive and reiterating market themes we talked about in lamenting the ever-challenging investment environment, I would like to describe in more detail the platform and strategies we put in place on this call, which have Annaly prepared now more than ever to maneuver in these demanding and volatile markets.

I will begin by further framing our capital allocating and financial 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 the balance sheet that merit this enhanced disclosure.

Over the last 12 months, with the relative and height volatility and 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 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 investment and assets with complementary cash flows also involved the diversification of 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 mono line strategies face especially today.

In addition to our wrote and diverse repo counter party relationships, secured warehouse lines, and our ability to structure leverage or securitize parts our loan portfolios, Annaly maintains the largest available balance in the sector with the FHLB of Des Moines, and has benefited from direct repo through our broker dealer, R Caps Securities, which has been in operation since 2008. While others are now just attempting to establish their own broker dealers, R Cap is another good example of a proprietary business we developed over time. While we have not marketed this part of the franchise, provides unique value to our platform.

Next, it is 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 have 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 have also recently illustrate the operating efficiencies of the Annaly hybrid business model, summarizing operating expenses as a percent of average equity and assets.

Following disciplined cost-cutting programs in 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. When these ratios and other measures are compared against the top 10 largest hybrid REITs in the sector, Annaly's operating efficiency is even more apparent.

In addition to our efforts to the maintain superior operating leverage, we have sharpened our focus on improved corporate governance practices, and this year will introduce a broad employee stock purchase plan; whereby a 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 of the past few years, something not done in the sector.

Finally, in regard to our outlook for 2016, let us just say we are not surprised by the macro economic headwinds, central bank policy divergence, and certain geo-political events since the start of the year. Against this increasingly challenging backdrop, the largest, most diversified investment platforms are favored. Our plan is to make the most disciplined optimal investment decisions based on risk-adjusted value and return. We will continue to balance the liquidity of our agency strategies with our lower levered floating rate credit alternatives.

We will not just diversify because we can. Our shareholders' onus for conservative portfolio management and income, and in the market with limited income alternatives, Annaly is billed as a unique and efficient yield manufacturer with multiple investment and financing options; and allows us to take advantage of current market volatility, expected industry dislocations, and unforeseen opportunities we been waiting for. Now I will turn the call over to David Finklestein to 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, the yield curve flattened, and NBS experienced further spread widening. In spite of this volatility, our low leverage and conservative positioning abled us to generate modestly positive economic return on the quarter. Prior to discussing our outlook for 2016, which is obviously of great interest to investors given the turbulence that has characterized all finance markets thus far this year, I will briefly recap the fourth quarter.

I will begin with residential credit where the more notable activity occurred in the portfolio last quarter, as we added just over $500 million in non-agency assets. Residential credit spreads widened modestly in the fourth quarter, and further weakened thus far in 2016. We welcome this spread widening as view it as primarily technical, along with the decline in broader risk assets, rather than reflective of the fundamentals of the US housing market. Our credit portfolio is still relatively small which enables to us opportunistically take advantage of cheap evaluations. In other words, recent spread widening more than compensates for the moderate shift in sentiment regarding the state of the US economy and housing fundamentals overall remain healthy.

As can stands today, while we are respectful of market volatility and elevated risk in liquidy premiums across the board, we do anticipate continuing to grow the residential credit portfolio in 2016. Turning to 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 lower loan balances as well as seasoned collateral. The continued spread widening left agency NBS LIBOR adjusted spread at the widest level 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 increase roughly 25% to 50% percent over the course of 2015.

In spite of slightly higher financing costs in today's market as Kevin discussed, we believe that are o 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 us 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 US financial conditions, and a 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 US economy, which remains sound, from the broader global economy notwithstanding tightening in US financial conditions. In particular, we view the recently much-discussed prospects for negative policy rates and extremely low or negative yields out the yield curve as only a remote possibility. We view the US economy and financial markets to be fundamentally different from Europe and Japan, and see the fed has having more arrows for policy easing in its quiver, that other major central banks, should conditions warrant.

And most importantly, central banks that have introduced negative rates have yet to prove their viability in achieving higher inflation rates. The negative rate debate should not distract from the importance placed the on the fed in cautiously carrying out monetary policy in 2016. We expect the fed to employ 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 an better investment environment going forward than we were faced with in 2015. And now I hand it over to Mike to discuss the commercial business.

Thanks, David. The fundamentals of the US commercial real estate market remain strong. We are 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 2016, both triple-As and triple Bs have reached their widest level since the last crisis.

In addition, equity REIT share prices are off a total of about 15% from peak levels reached in early 2015. We believe this is a 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 million 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 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% tenure treasury. Global investors continue to look to US real estate for yield, and capital preservation.

Although credit standards have tightened and spreads were 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 leverage yield of 9.1%.

In addition, we are 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 is diversified by geography, sponsor, and asset class. We remain concentrated the in the office and multi-family sectors, which combined make up 68% of our portfolio.

Our less exposed-to the hotel sectors 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 have discussed on the past few 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 security (inaudible) to be profitable. With the strength of our capital position and the depth are 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. Reservation of capital is our priority while we provide our shareholders with longer-term, primarily floating-rate cash flows as strategic complement to our agency portfolio. With that, I would like it 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 profiles to the business line; we also provided additional detail on various financing sources, including rates 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 businesses.

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 is 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 the decline in projected launch on CPRs to 8.8%, in comparison to 9.2% the prior quarter. The component of premium amortization due to the change in estimate the long-term CPRs 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, a combination of both higher income within the agency portfolio, as well as higher income from the commercial investment portfolio; partially who offset by a higher repo funding cost. All of which contributed to improvements in both normalized net interest margin, net interest spread, as well as our normalized core which was 10.3% for the fourth quarter compared to 9.7% for prior quarter.

Consistent with Kevin's remarks, concerning operating leverage and focused around operating efficiencies, we consistently maintain a focus on both scale and efficiencies of our operating platform and overall expense structure. Total operations expenses $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 a 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 traditionally reported was 5.1 times, and economic leverage, we ended the year at 6 times. And lastly, during the quarter we began purchasing shares under a previously announced $1 billion share repurchase program. To date, we have purchased $23.1 million shares, totalling $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. With that, we are ready to open it up for questions.

Thank you. (Operator Instructions). We will pause momentarily to assemble our roster. Our first question comes from Douglas Harter of Credit Suisse. Please go ahead.

Hi, this is actually Sam Cho filling in. I was just interested in hearing about where are 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 is Kevin. I will give you the bigger picture and then I will let David and Mike and the rest of the team fill in the gaps. I mean, I think the good position that we are in is that we are not a mono line, and we have as I mentioned in my prepared comments, diversified strategy. You know, the four businesses, our agency, RESI, credit, commercial and middle market lending. And I think I would say a couple 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 is not exaggerating.

So I think the beauty of it is we have, you know, multiple options. If you want to corner me today and have me force rank those options, I think it has, you know, been demonstrated over the past couple quarters that we think there is value in shifting into certain types of the credit at certain times, given the nature of the cash flows and the lower leverage profile and oh, by the way, these businesses tend to protect book value quite well amidst of volatility. I think RESI credit obviously grew the most last year. Think our outlook is that it will free this year but not at the same pace. Obviously, we are going to be starting from a bigger base in terms of capital. You know, middle market lending is a business we had here since 2009.

And we have not talked much about it. It has been a patient grower. Very similar to other things would very done here over the past. That business will grow consistently, just based on what is happening in the marketplace with other participants that by definition the competition is kind of coming to us. Commercial real estate, you know you heard Michael's comments. We have grown that business nicely. We have, really, a strategy that is 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 is 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 any of these credit strategies. So, I summarize it that way. It is really I think RESI credit and middle market lending improved last year, and they will continue to grow. Commercial will be relatively lumpy to the two businesses, but overall these businesses have to compete with the agency strategies, which you know in this market have gotten 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 were talking about your financial -- the funding position and talking about the flexibility, you mentioned R cap 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 (inaudible) fully operational. And what kind of first mover advantage does that offer for you guys?

I am not going to comment on how long that takes other people to do it. We established a broker dealer, like I said 2008, and you know it takes a lot of work. It takes a lot expertise, infrastructure, systems, legal, technology. So, you know, I think in terms of first mover advantage we had it for eight years or so. I do not know if that is first mover or not, but that is a decent period of time.

I think we have not talked much about it because that is one of the many sources of financing, part of the strategy to diversify, frankly, into complementary assets was complementary financing out there from our relationships. You can not do one without the other. I think R cap is a critical element that, let me put it this way, we are glad we had it in place as long as we have.

Got it. Thank you.

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

Good morning guys, it is Eric on for Bose. How you think about taking realized gains in certain areas of the portfolio as you rotate into new strategies?

That is a good question. When we think about the accounting consequences of shifting the portfolio 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 is a consideration nonetheless.

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

You are 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. Also have a rather large IO portfolio which has negative duration and positive yield, and to the extent that sector cheapens up that is an alternative to reducing the hedges. But our hedge position has been relatively stable for the past year, and there is no immediate plans to reduce that, particularly given where rates are currently.

Got it. Thanks, guys. Appreciate it.

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 are saying is there have not been changes yet; theoretically there could be. But it sounds like, and I do not want to put words in your mouth, sounds like given how low rates are right now, you are kind of hesitant to lower the head on 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?

This is David, Joel. That is a good way to think about it. The current environment, we want to maintain enough duration in the portfolio to keep our heads above water. If the market should further rally, but not too much duration where we will not be in good shape with in the event of a sell-off. We are very cautious with respect to rates here, and playing it down the middle on that front and look for alternative hedges should the environment suggest we do so.

Okay. And as a follow-up, if you know, we saw better growth prospects, with presumably higher rates; would that be what you are looking for to perhaps reduce the hedge on the agency book?

Potentially, and higher rates would naturally extend our duration. We are 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 are still about half a year. Some of that would come through extension of the portfolio. There is certainly a level where we would take more rate risk, absolutely.

Okay. And lastly, you know, given your comments about, you know, 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 are saying in non-agency right now are kind of comparable to agency, but they could be higher you just -- it is just not something that you want to lever in this type of environment is that a fair characterization?

I would say we do not have to lever as much in the non-agency space currently. If you take credit risk transfer, for example, where the most recent fuel price which on the second loss piece for the low LTV bucket was 675 basis points, you can fund that at LIBER plus 165, 175. One turn of leverage gets you double-digit return. So given where credit spreads are at, it is not as necessary to take as much leverage. Should the fundamentals change and spreads tighten and we are much more comfortable, we will certainly add leverage to the business and also capital.

Joel, it is Kevin. One thing I would add to take a step back. Among all of the credit businesses now that they are of obviously more scale this time versus where they were this time last year, our plan is to obviously optimize the capital and have incremental structural leverage put on the businesses that was not there because we did not have the size. So, you will see if we do our job, we will have a more efficient use of our capital with the underlying leverage in these businesses in any growth scenario going forward this year.

Great, thanks for the color guys.

Thanks, Joel.

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

Thanks for taking the question. Seeing a huge amount of volatility just since December. One item is obviously the flattening of the curve; 2s, 10s 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 markets rally, the curve has flattened. Agency spreads have widened a little bit. I would think about it currently in agency yields 280 to 285 there about. The hedge in financing costs about 150 to 160. And you apply six times leverage to that and still get low double digit returns in terms of absolute returns and spread. Is that helpful?

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 reclass or anything from the third quarter to the fourth?

No, no.

Okay. Thanks. I will follow up offline.

Thanks, Brock.

This concludes our question and answer session. I would 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.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.