Annaly Capital Management Inc (NLY) 2017 Q3 法說會逐字稿

Good day, everyone, and welcome to the Annaly Capital Management Third Quarter 2017 Earnings Conference Call. (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'll 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 smug 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 gains, corporate high-yield trading at a 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 risks 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 and 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 at all-time lows, as measured by its Sharpe ratio and assets return relative to its volatility the Dow would have to gain more than 70% over the next 12 months to match its 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 evolved 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 consistency 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 3 successful transactions, we attracted over $2.4 billion of growth capital, the most primary proceeds raised in overnight offerings 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 transactions serve as a clear endorsement of the successful execution of our diversified strategy in out-performance 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 raised 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, insiders, Board of Directors and financial sponsors cashing out of their positions. So while others are selling into this market's overvalued bid and taking their own money off the table, we're doing the opposite and investing alongside our shareholders. In addition to raising this accretive capital, earlier this past quarter, every member of Annaly senior management team including myself committed to increase their own voluntary stock ownership over the next 3 years. I think I'm destined to reiterate this on every call, unlike all others, we are buying our company's equity. We are not being granted stock and then selling it back into the market.

Prior to the 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 spread tightened modestly while the pace of spread tightening has begun to moderate in certain credit sectors and whole loan markets remained attractive.

Given the fundamental valuation issues in these various credit markets, we've 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're not bidding blindly in a 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 dynamic, through our sponsor relationships, we're able to access more defined attractive niche in the industry in which there are 30% fewer Covey-like transactions than the over picked broadly syndicated market.

Within the residential credit industry, underwriting standards continue to be quite stringent for the GSEs and banks, evidenced by the fact that the average GSE purchase FICO the end of 2016 was 755, which has declined only 1% in the past 5 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 markets businesses, while not sacrificing credit quality to achieve double-digit lower level floating rate returns complimentary to our Agency strategies. As the third quarter earnings season has commenced for our sector, the conversation continues to center solely around 3 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 4 main businesses. Our company size is 20x the 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 a 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 under-capitalized 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 cost 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 than 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 Sharpe 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 yield 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 surreal 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 activities.

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 increasing 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 raise as a significant portion of our additions were purchased prior to quarter end. But as we discussed last quarter, we are comfortable operating a modestly higher agency leverage given the subdued interest rate volatility in the current environment. Specifically, with respect to our agency purchases, we added nearly $20 billion in assets, almost exclusively in 30-year pools and TBAs. 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 the agency multi-family DUS securities in the quarter. This is another reflection of diversification within our agency portfolio as DUS 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 run off 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 and term repo as interchangeable tools in navigating the front-end of the yield curve in a financing environment, which we consider liquid.

Shifting to our credit businesses, as Kevin discussed, the broad demand for credit assets in 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, bounce and volatility in 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 maintain the size of that portfolio in spite of roughly 10% runoff, but as we have 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 have 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 quality and diversity of our lending counterparties.

And with that, I'll hand it over to Glenn to discuss the financials.

Thanks, Dave. Our third quarter financial results once again highlight the strength of the Annaly franchise and its ability to generate consistent financial performance. So beginning with our GAAP results, we reported net income of $367 million, $0.31 a share. From the factors driving results for increased net interest income, improved marks on 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 a share. The PAA for the quarter was approximately $0.04. Comparable second quarter core earnings excluding PAA were $333 million or $0.30 a share with a PAA close to $0.07.

Some key factors contributing to the comparative quarterly results were higher 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 as both repo balances and cost rose for the quarter, which was partially offset by lower net swaps expense and together represented higher economic interest cost of about $0.02.

Additionally, approved dividends on preferred shares increased about $0.01, primarily due to the recent Series F issuance. As Kevin mentioned, we declared a common stock dividend of $0.30 per share, marking the 16th consecutive quarter at that pay-out level. And of note, we also included in our core earnings per share computations cumulative and undeclared dividends of $8.3 million in the 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 its first long dividend period and is scheduled to be declared and payable on or about December 31.

For the full long period dividend with reduced book value in Q4, which is when we would expect that dividend to be declared. Our financial metrics remain strong with core ROE excluding PAA at 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 assets at about 25- basis points, OpEx equity at 170- basis points. Book value increased 2% to $11.42 a share and economic leverage ended the period 6.9x. 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 was accretive to book value and contributed to balance sheet growth of approximately $12 billion with the increase largely coming from the agency portfolio and combined with TBA purchase contracts, the aggregate investment portfolio ended the quarter up $19 billion. Origination from new investments across our credit platforms was solid representing over $500 million in the quarter with a net growth of somewhat tempered by pay-downs. From a capital allocation standpoint, as David has mentioned, credit portfolio represented 23% of allocated capital at the end of the quarter. And finally, during the quarter we completed the restatement of our Series A preferred, which when coupled with the Series F issuance reduces the economic cost of our outstanding preferred 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.

(Operator Instructions) And it looks like our first questioner will be Rick Shane with JP Morgan.

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 at this point or are you still, is that a place you want to deploy capital?

Rick, well, it's kind of consistent with the past couple of years where we have these episodic opportunities in different parts of the cycle within either a quarter or a month or 2. I would say, yes, and yes, I mean we just raised a bunch of capital predominantly because of the relative value in the agency assets that we can procure. And with the recent uptick in valuations there, some things 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 are seeing pockets -- sometimes the credit lead time is obviously longer than the liquid business that we do on the Agency platform. But I think going forward, our credit backlog is actually larger without sacrificing quality in terms of dollar amount and number of deals than it has been in the past couple of quarters and there is 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 markets 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 are 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 and their businesses it's all relative value measurement and I think we really do -- we literally do a deal-by-deal, asset-by-asset, relative value risk-adjusted comparison and the best return on that basis wins. So going forward, I would think -- our balance now is 23% credit. Everything is expensive to my comment, Agency is frankly less expensive and easier to hedge and more liquid. So that's why we put that money to work the past couple of months, but like I say going forward we could flex into more credit, we're just waiting for that -- for the valuations to adjust.

It seems interesting. I was going to say your -- the velocity with which you can access and deploy capital is pretty unique.

Yes, I mean, I think -- that is why I don't really compare ourselves to this sector, we're self-financed -- we're self-financed diversified managers. So we don't have to wait or rely upon outside sources to transact, and with our pay-downs that we've talked about -- EUR 800 million to EUR 1 billion a month that's cash flows in a market that we -- that is why we kind of waiting and appreciating more volatility because that's when we can use that liquidity and take advantage more than most any other financial company of our size.

And one specific question, do you guys still have any exposure to 111 < 57?

No.

Do not.

And our next questioner today will be Douglas Harter with Credit Suisse.

Just wondering your thoughts hearing what you're saying about kind of 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 kind of how you are reviewing that risk trade-off today?

Well, for -- Hi, Doug, for 4 years in a row now, 16 quarters, we have been paying you 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's only really been two volatile quarters in the last 6 and that's when we've either bought a company or grew our credit businesses. So how I look at it now is we're in this earnings season and my commentary is, I think is meant to be constructive that, I think the market is -- valuations have kind of contracted here a bit because of the market figures if you're a 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 are in those asset classes but we're also in 3 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 is not reflected in the equity market in terms of what's going on in 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 stability of our return, which overwhelms the rest of any one of our mortgage REIT peers. I mean there has been -- 80% of the sector has cut their dividend over the time that we have not and we protected both twice as better or 3x 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 point to 4 years ago, we have been able to produce stable earnings and protect both better than anybody and in the volatile times is when we frankly get more aggressive.

And our next questioner today will be Bose George with KBW.

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

Sure, Bose, this is David. Turns in agencies right now on a levered basis to 8x leverage are 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.

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, I mean, we're -- obviously actively involved in -- across markets. For example this last quarter, moving into the DUS 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 are 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 have not opted to go into and what we found is that, finding partners as we 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 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 we constantly evaluate everything and then on the commercial side, I can hand it over to Mike to talk about.

Yes, 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 and then we're constantly evaluating the relative attractiveness of each of those investment opportunities. 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 businesses 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 in press release, best-in-class, a premier lender in that space. The assets are range from co-op housing to charter schools to health care, 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.

And the next questioner will be Ken Bruce with Bank of America Merrill Lynch.

I have a couple of company specific questions and then kind of a bigger picture question. I'm trying to reconcile, I guess, some of the comments around kind of 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 that David had pointed out, that just with volatility being so low, you just kind of have to take a little bit more leverage to get paid.

Yes, Ken, this is David. I'll address the leverage question first. At quarter-end our leverage was 6.9x and as I said in my prepared comments, we did acquire 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 and the assets added, our leverage would have been 6.75x. So just up a little bit from 6.4x. Our view is that -- and as we have 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 and then about another $2 billion subsequent to that. The convexity profile of the mortgage portfolio is as 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 wrench-in, in September but we -- it's important to note that they 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 6.75x to 7x leverage with the current market environment.

My comment on -- 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 it without the growth behind it -- certainly not on a one-to-one basis which 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 have been talking about.

Right. And just if there is any rationale or color around -- just noticed the weighted average days of maturity on the REIT bill agreement's dropped pretty significantly and has been. Is there any -- is that just a -- 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 kind of interpret from that progression?

Yes, sure. Ken, this is David again. And yes, as I talked about in the prepared comments, we have looked more towards the euro dollars market to hedge that very short-term rate risk and that does have to do partially with our level of comfort in 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 then 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 fundally available.

And my broader question is, is that there is still this ongoing debate as to what to do with that GSEs as it relates to the cash sweep and capitalization and the like. And I'm interested 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 kind of a more of the same, I mean, we're in the room in DC and we spent a lot of time there in terms of the different potential reform. I would say that related to your question is Chairman Hensarling's decision not to run or seek reelection, to us signals that there could be more beneficial change around the edges, certainly around potentially legislation around the FHLB membership and some of the housing and 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 have been saying GSE reform is already taking place without legislation in the form of all these risk sharing deals which we're not only participating in, we're 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 and when that happens, it's kind of 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. Maybe on just -- maybe just an opportunity for politicians to be shrill about certain things but obviously the housing part of the food chain has pushed -- pointed to or is alarmed about I guess the lack of capitalization. So I was wondering if there is anything on the back end that you guys would focus on, it does not sound like there is so.

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.

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