Orchid Island Capital Inc (ORC) 2018 Q4 法說會逐字稿

Good morning, and welcome to the Fourth Quarter 2018 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, February 22, 2019.

At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent annual report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.

Now I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir

Thank you, operator, and good morning, everybody. Welcome to our call.

I hope everybody has had a chance to download the slide deck off of our website. I also saw that Seeking Alpha had them out there this morning. So I'll be going through the slide as I normally do. I may skip a few, but I will not go out of order. Many of these slides are slides that we use every quarter, so if you're a regular listener, you should be accustomed to seeing these slides.

I'll start on Slide 3, which is basically just the table of contents. Just run through a quick outline of what we're going to discuss today. We'll start off with the financial highlights of the quarter ended December 31, 2018. And then we'll spend some time, as we usually do, talking about market developments, and this was a significant quarter for the markets and the outlook for the economy and rates going forward. Then we'll discuss our financial results, portfolio of characteristics and then our outlook and strategy.

Turning now to Slide 4. The financial highlights for the quarter. Orchid Island reported a net loss per share of $0.52 for the quarter. This included $0.80 of incurred losses per share from net realized and unrealized gains and losses on RMBS and derivative instruments, including net interest income on interest rate swaps. Earnings per share of $0.28, excluding unrealized and realized gains and losses on RMBS and derivative instruments, including net interest income on interest rate swaps.

And we have Page 18 in the slide deck for reconciliation of that. Book value per share was $6.84 at December 31, 2018, a decrease of $0.72 or 9.52% from $7.56 at the end of the previous quarter. Total dividends paid for the quarter were $0.24.

In 2018, the company declared and subsequently paid $1.07 per share in dividends. Since its initial public offering, the company has declared $10.065 in dividends per share. Economic return for the quarter was negative $0.48 or 6.35%, $0.80 per share and $9.18 for the year. The company repurchased 3,380,536 shares between October 31, 2018 and January 3, 2019, representing 6.5% of the shares outstanding as of September 30, 2018. The company has repurchased 10.43% of all shares issued since inception.

Now turning to Page 5, our return data. What we see here is our returns broken down by different periods. On the top, we have the annual returns for our stub year, after our initial public offering in early 2013, the years 2014, '15, '16 and '17; and then our more recent 6-month return 1-year look back 3, 5 and since inception; and then the quarters for '18 and the total year of '18. This is also shown versus our peer average. Our peer average is defined in the bottom of the page. It includes Annaly, Anworth, CMO, Cypress, Armour, Hatteras, Agency, Arlington and Dynex. And of course, Hatteras and Cypress were only included for part of the period as they were acquired at different points in time.

As you can see, after Orchid's IPO in 2013, we have generally faced upward movements in rates and a flattening of the curve, and it's somewhat reflected in the results. As you can see, the early returns were quite large and then slowly declined. And of course 2018, which really represented the peak in the tightening cycle, with rates moving higher for most of the year, the results were negative 9.2% total return using book value versus stock price, but that still is slightly better than the peer average. And also for the fourth quarter, which we're here to discuss today, negative 6.3%, so obviously a very rough quarter, but also a slight outperformance versus the peer average.

Turning now to the Slide 7. This is just a snapshot of the yield curve. On the left-hand side, we have, what we call, the cash market or the Treasury benchmarks, and on the right-hand side, the dollar swap curve. And as you can see, this was a very pivotal quarter. We had a significant movement in the curve. The green line represents the various respective curves at the end of the third quarter. The red line is at the end of the year. Then the blue line is through last Wednesday. You can see, since the end of the year, rates have not moved much here in swaps or in the cash market, but we did have a very significant move in the fourth quarter. The fourth quarter of 2018 is, in all respects, an extremely pivotal quarter. It's quite remarkable when you consider what happened over the course of the quarter. So for instance, at the very beginning in the quarter, on early October 3, the Dow hit an all-time high. Oil -- WTI oil was at a multi-year high. In terms of economic growth, the outlook was very positive. In early October, the unemployment rate printed at a 49-year low. Wage growth was accelerating. Global growth, while certainly nothing like the U.S., was still seen to be kind of warm. Confidence in the markets was extremely high. And in the September Fed meeting, Chairman Powell stated that the Fed was a long way from neutral, and that they may actually pass through neutral. Fast forward to the end of the quarter, pretty much everything had changed materially. With respect to the markets, the Dow and all the major indices had made -- come to a significant correction. We're actually in a bear market. Year-to-date gains were all gone. WTI oil was down 43%, peak to trough. In January, risk assets of all type were suffering mildly. While the labor market, in terms of economic growth, was still positive, the ISM measure, which is a significant metric for the market, had a meaningful decline, the largest decline we've seen for 1 month in 11 years, and various other measures, home sales, new and used, had plummeted.

Global growth had appeared to change dramatically. China had -- each successive quarter of 2018 was lower than the last quarter at 6.4%. Growth for the year was a 28-year low. Europe, things were even worse. Many economies reported negative growth for the third quarter, including Germany and Italy. Confidence, obviously, plummeted. The markets hit a year-to-date low on Christmas Eve, which was right around the time the government shutdown was starting.

With respect to the Fed, while they had said that they were long way from neutral, at the end of the third quarter, they now saw themselves at the end of neutral. And in fact, at their January meeting, they said they were falling within the range of neutral, had become data-dependent and the next move could be either a hike or a cut. So obviously, a very significant turnaround in the fourth quarter.

Turning to Slide 8. We'll just go through, kind of, fairly quickly, since I'm sure this is all relatively all news to everybody by now but there are some key takeaways that I want to point out. So for instance, turning to Slide 8, we see the movements in the 10-year Treasury and the swap, both for the quarter and a 2-year look back. You can see in the fourth quarter, we have this meaningful move, but what's noteworthy is that we've stabilized since year-end. In fact, both swaps and in Treasuries, we've actually gone into a relatively narrow range. With respect to the 10-year, it's roughly 2.60% to 2.70%, and the market seems to have stabilized. But keep in mind that Fed funds, as we speak, is at 2.41%. So a 10-year between 2.60% and 2.70% is quite a flat curve. In fact, the 2-, 3- and 5-year points at the curve were all in the low to mid-2.50%. So marginally above Fed funds. So quite a flat curve.

If you turn to Slide 9, this is just another depiction of the same basic thing. You can see we've been in a multi-year flattening cycle. The bottom chart shows the green line, which is just the spread between the 5-year in Treasury note and the 30-year bond. It has been declining for multiple years. It actually troughed last July, but with all the developments in the fourth quarter, it has actually started to steepen again. And since the market's view of the rates going forward and the Fed has changed so dramatically, this steepening is generally being driven by the 5-year. The 5-year part of the curve is typically the most sensitive to the path of Fed hikes or cuts and is usually driven by the market's perception of the terminal funds rate for the next cycle. So to the extent the economy were to soften further and the market will start pricing easy, you'll probably see the 5-year part of the curve lead the rally and cause that part of the 5-30 curve to steepen.

Turning now to Slide 10. Kind of go back -- get to our neck of the woods, which is the mortgage space. And what we show here is just the relative performance of the various 30-year fixed-rate coupons, in our case, it's Fannies. The blue line represents the Fannie 3, the reds are 3.5, the green is a 4 and then the -- or I'm sorry, the gray is a 4 and the green is a 4.5. This is performance versus hedge ratios. And as you can see, it was quite a rough year, particularly so in the fourth quarter. What was also noteworthy is that there was clearly a coupon bias and, by that, I simply mean that lower coupons did better, more duration. And as you can see, in the fourth quarter, higher coupons did particularly poorly. However, again, looking at the development so far this quarter, 219 -- or 2019 has seen stability and, in this case, recovery as these relative performance has actually gone the other way.

Turning to Slide 11. Four charts here, which kind of just gives us a little deeper dive on the same thing. Again, the top left, we're looking at the price of the Fannie 30-year 4 and 4.5. As you can see, they've actually stabilized and tightened somewhat. That's somewhat misleading because there's a lot more going on. The bottom left chart shows the roles for these securities. And it captures the fact that they've plummeted, something we've seen now for several months, and that is exchange in the TBA deliverable, in other words, what is being the kind of the cheapest to deliver collateral that is delivered into the TBA market.

And it's been very uniformly poor in quality. And the reason it's so poor is several fold: one, the spread between the gross WAC and the net WAC on all of these has grown far above norms, in some cases approaching 90 and 100 basis points. The average loan balances are higher, and FICO scores are higher. So as a result, the characteristics -- the convexity in these securities is deemed to be very poor. So what's bad for the TBA market is good for the specified market. In the top right, you see the pay-up for certain key loan balance pools, and they have certainly recovered. And we continue to see that into 2019. Bottom right just shows the pay-up for new pools. And consistent with what we've seen in the deterioration and the TBA deliverable, those levels are essentially 0.

Turning to Slide 12. And this is rather a key, especially for the outlook. So as I said earlier, higher coupons tend to deploy in the fourth quarter and really throughout the year. What we're showing here is the LIBOR OAS by coupon over the course of the fourth quarter. But in this case, the higher coupons are wider, which just makes sense, because their performance was worse, so their spread was widening, but the LIBOR OAS that they offer is quite high and very attractive. So these securities now, going forward, represents very good value to us and good sources of carry. On the left-hand side, we're just looking at the TBA. On the right, we're looking at specifically the 4.5% coupon of various specified pool buckets. And as you can see, these numbers are very attractive. And that is very key for us in our -- from our perspective going forward.

Turning to Slide 13. I won't spend a lot of time here. These are the, what used to be the Lehman Aggregate, now the Bloomberg Aggregate Index returns for the year. As you can see, on the left-hand side, these are absolute returns. So the aggregate itself generated a return of essentially 0. Mortgages were a slight positive 1%. The start for the year, by far, was nonagency MBS, which was 3%. On the right-hand side, we show the same returns versus treasuries. The aggregate had a slight negative return as did mortgages, but again, nonagency mortgages did very well.

And just wanted to make a point here: early on, I talked about our returns and how we did versus our peer average. We remain a fully all-agency portfolio. So while over the course of 2018 and '17, for that matter, nonagency credit did extremely well. We've been able to generate returns consistent with our peers, in some cases, better without any credit. And so to the extent moving forward that the economy would roll over and the consumer were to weaken and the credit would be somewhat exposed, we are very well positioned since we have no exposure whatsoever to any of those risks.

Finally, on Slide 14. This is volatility. We're using a 3-month swaption on a 10-year. There are 3 lines. One represents out of the money, the other 2 are slightly out. In the case of the red line, it's a 25 basis point out of the money receiver swaption, and the green is a payer. But what I want to point out is, you can see the spike in volatility that occurred at the end of the year. But note how much it's fallen off since. Not only is it stabilized, but it's stabilized at a really low level. There's an index you can pull up on Bloomberg called the MOVE Index, which is similar to this, and it's at or near an all-time low. So for mortgages, that's a good thing. We like to see low volatility because we are short to prepayment option in all cases.

Slide 15 just shows you rates, whether it's LIBOR or Fed funds. The simple takeaway here is that we're probably at or near our peak. And this is more evident on Slide 16. What we're showing here, in all 4 slides, there are 2 lines. The red line represents the Fed's dot plot as of the respective meeting. And the blue line reflects market pricing of Fed funds going forward. It's derived from the Fed funds futures market. So for instance, on the bottom, if you look at the September '18 meeting, the red line was well into 3s -- nearly 3.5%. So in other words, Fed hikes, at least, based on Fed expectations, we're far from where we are today at 2.40%. The market was approaching 3%. By the end of the quarter, you can see the dramatic shift. Fed expectations were much less, and the market has gone from pricing in close to 3% to essentially pricing in a modest probability of a cut moving forward. So a very crucial quarter. And as we turn now into our financial results, this will become clear why we think this is so pivotable.

On Slide 18, we show our results for the quarter. The left-hand side is where we try to show -- this is our kind of proxy for poor income, which many of our peers produce. It basically just represents our income absent mark-to-market issue or gains and losses. And as you can see, it foots to $0.28. But we did have significant mark-to-market gains and losses, and the predominant one was the movement in interest rate futures. As I've been saying, mortgages had a rough year in this particularly quarter versus their hedges. And in the case of the fourth quarter, they were the driver of our overall performance. Mortgages did okay in terms of going up in prices, particularly pass-throughs, but the hedges overwhelmed performance. And that's really reflected on the right-hand side. This is our typical table where we show results by sector, where we allocate capital. The first column is the pass-throughs. As you can see, the derivative losses or material, they drove the results for that sector to a negative 7.7% return. IOs had a negative return simply because the market rallied. Our inverse book did very well, had a 9.8% positive return, but because this was capital allocated there, it did not offset. The other sector zones resulting net for the entire portfolio was a negative 6.5% return.

Now we'll turn to Slide 19. And I think this slide is very important from -- respect of not just where we've been but where we think we're going. As you can see here, over the last 5 years, our net interest spread, as the curve has flattened, has been slowly eroded. And for the last few years, our NIM has been in the low 2% range. So we've had a very long tightening cycle that accelerated in 2017 and '18. As a result, we had to position progressively more defensively, add to our hedges, more specifically, our front-end hedges. And as a result, it put a lot of pressure on our earnings. However, prior to that period, before the tightening cycle had intensified, we were issuing capital to our ATM program, because the shares were trading above book. Since we've had to make cuts in the dividend, as you see on the bottom part of the table, the stock has trended below book, and we've been aggressively buying back shares. As I mentioned, we've bought back almost 10.5% of all shares issued. And this is a key part of our strategy to maximize our book value performance by either selling above or buying below, and it's part of the reason that our returns are where they are.

But what I want to point out here, and this is really key going forward. If you look on the far right part of the page, you can see stability. With respect to the NIM, it's been running in the low 2s, but it's done so for several quarters, and our dividend has been at $0.08 all the way through February of this year. Going forward, we think the Fed appears to either be done or close to being done. And we have excellent carry in the assets we own. We talked about that earlier, and we talked about the various higher coupons securities that we typically own, whether it be LIBOR OAS or any other measures of carry. They look very attractive. And we have no credit exposure. To the extent that there is any kind of a downturn, we will not be exposed. So given all of that, we feel that returns going forward should be stable. And actually, there may be upside to the extent the economy softens further and the Fed were to lower rates.

Before I wrap it up, I would like to just say a few things about our capital allocation, portfolio composition and our hedge coverage.

I'm going to skip ahead to Slide 21. This, on the left-hand side, shows the allocation of the capital. As you can see, over the course of the quarter, the pass-throughs, for instance, went from 65.2% to 58.5%, we had a structured increase. But I want to point out, this was not so much of a -- it was a combination of a strategic decision to shift away from pass-throughs. But also because of the book value pressure and the leverage, we had to reduce the size of the balance sheet, that's also reflected on the right-hand side. And most of the reductions were in the pass-through portfolio. So for instance, on the right-hand side, you can see the market value at the end of the last quarter was nearly $3.4 billion, and now it's well under $2.9 billion. The increase in capital allocation to structured was modest, but simply, it just kind of gained on a relative basis through attrition because the pass-through part of the portfolio was where most of the declines took place.

Jumping ahead to Slide 23. This is just the composition of the portfolio. Again, the changes were more driven by what was reduced versus what was added. Fixed rate CMOs in 15 years increased modestly versus the end of the third quarter, simply because they just didn't decline. Most of the sales were in the 20-year and 30-year bucket, and so those 2 buckets reduced slightly. But also, keep in mind, the coupon distribution is still very much the same. As we said, those coupons, while they had a rough quarter, are posed to do very well going forward, offered very good carry. Going forward, we may actually add slightly to the duration, simply because of everything else we said so far in terms of our view. It does look like the Fed is at or near the end of its tightening cycle. And we would expect if and when they also reduced -- eased that we would see declines in rates, and therefore, we'll have a more significant positive duration gap.

The final slide I'll refer to is Slide 26, which shows our hedges. As you can see, we have all these different hedge products. The top left is our Eurodollars. On the right-hand side, we have swaptions, which now are actually gone.

TBA positions and swaps. The swap positions, in conjunction with our Eurodollars, effectively care -- cover all of our funding cost, repo balances, that is. So to the extent there are more Fed hikes, we've essentially locked in a rate, as reflected on this page, 2.51% in the case of the Eurodollars and 1.70% in the swaps. But as I said, we do think that we're at or near the end of the cycle so that we would think, over time, that the percent of our repo funding, that hedge will decline. So whether it's through growth, if we were able to access the market through the ATM program, for instance, or just trading that, that coverage would start to come down.

And with that, operator, I will conclude my prepared remarks and turn it over to questions.

(Operator Instructions) Our first question comes from Christopher Nolan of Ladenburg Thalmann.

Bob, looking on the portfolio allocation -- I'm on Slide 23, that you highlighted. By the way, thank you very much for all the great commentary. And I saw you guys lined up on the 30-year 4.5s. Is that sort of an indication by expectations for you that prepays are going to start spiking up, in general?

I'll say a few words, then I'll turn it over to Hunter. I would say, no. We actually had the benefit in the last few months of being in the seasonal trough. And we have seen a rally in rates, although that has since kind of abated. We are coming out into the -- where we typically see a pickup. We've been adding forms of pay-up protection typically lower pay-ups. So even if we do see some modest uptick, the combination of fact that we're still a relatively higher mortgage rates and we do have forms of call protection, we would not expect to see a spike. I'll let Hunter say more about that.

Yes. A lot of that, Chris, just had to do with the fact that, as Bob alluded to, we were both trying to manage our leverage in a choppy market in the fourth quarter. And we were also aggressively buying stock back and shrinking the equity base. So we were selling 4.5s because that was the biggest and most liquid part of the book. So the 15 years that we owned -- we lightened up on this a little bit into the first quarter, those were largely loan balance. So end of the rally, we figured we -- it's best to hang on to those. The CMOs were not something we really wanted to sell in the fourth quarter because they're not nearly as liquid as the pools that are backed with -- that had a TBA backstop. So it was really just sort of a hodgepodge of 2 different varieties of 4.5s.

All right. And talking about buybacks, I see you guys were pretty active in the quarter. What's the thoughts for further buybacks going forward?

Well, we're not going to change to the extent that the stock trades materially below book. We have an unofficial level of about 90% of book, but that's not etched in stone. We will buy back shares. And when the bottom fell out of the market in December and the stock traded down appreciably with all other -- pretty much everything else, we got very aggressive. And as I said, we brought back 6.5% of the shares that were outstanding at the end of the third quarter. We are an externally managed REIT, and I don't think that's typical, that type of aggressive buying back of shares. But it's -- it helps drive returns because we're doing so -- adding to book value. In the course of the fourth quarter, when book value is being pummeled, you're kind of netting some of that up by buying back shares so accretively.

Bob alluded to the fact that risk markets behaved pretty poorly in at least the second half of the fourth quarter, but I guess, there is a silver lining in all of that. It was the equities, in particular, Orchid stock traded abysmally as well. So we were able to liquidate some mortgage assets that had done a little bit better than our stock price on a relative basis and buy back pretty aggressively some shares.

Yes, I wish some other externally managed companies that I cover were as aggressive buying back stock as you guys were.

(Operator Instructions) Our next question comes from David Walrod of JonesTrading.

Could you give us an update on where book value is, either today or at the end of January?

It was up slightly at the end of January. It's actually come back down. It's probably, more or less, in line with where it was at the end of the year. Most of the recovery we saw was in January, and we've since given back some of that.

All right. And then both from an asset allocation standpoint and a leverage standpoint, given the decline in equity, given your share repurchases as well as the market conditions, your leverage has picked up, your asset allocation changed, as you noted. How should we think about that going forward? Where are you putting run-off today? And how should we think about leverage, given the current equity levels?

Yes. First of all, the leverage we put in the slide deck, I think, it was 9.1. There were some unsettled sales, so it came off slightly than that plus the TBA short. So it's actually somewhat lower than that. It's closer to 8.4. We're probably going to stay at or near that kind of level. We were so defensive for so long with the tightening cycle that seemed like it was never going to end. And may resume tightening, but I think it's a stretch to think there's a meaningful amount of tightening still to go. So going forward, you would expect eventually to go the other way, who knows when exactly that will occur, but it seems like we're probably being range-bound here for a while. So we don't have a overly concerned with having that risk. We're very fully hedged, maybe too hedged, and so we'll probably take some of that off. And then it gets down to the securities yield, too, the IO securities, that should be the way Hunter says, but there's a lot of 2-way risk in those, so they actually ask -- have some true hedge benefit to them. So...

Yes. No, exactly and the fixed rate securities in and of themselves have much lower hedge ratios at this point in rates. So there is less need to hedge, so we would expect to curtail some of those to position. With respect to the portfolio allocation, as we alluded to, the percentage allocated to mortgage derivatives, CMOs in 15 years increased really just because we were selling 30-year fixed rates. So it will probably be the focus. We'll level the portfolio to back out, more in line of what you saw probably in the third quarter, maybe even a larger skew towards fixed rates, getting -- shying away from some of the hyper or prepay sensitive coupons, like 5s and 4.5s, and maybe going down a little bit in coupon. But I wouldn't expect to see meaningful changes. Just sort of redistributing the allocation back to where it was prior to the buybacks and deleveraging.

And this concludes our Q&A portion. I would like to turn the call back over to Mr. Robert Cauley for closing comments.

Thank you, operator. Again, thank you, everybody, for taking the time to listen. To the extent, anybody has any additional questions or only had a chance to listen to the replay, please feel free to reach out to us at the office. We'll be here all day, as usual. Our number is (772) 231-1400. Otherwise, look forward to talking to everybody at the end of the next quarter. Thank you. Thank you, operator.

Ladies and gentlemen, thank you for your participation in today's conference. You may disconnect. Have a wonderful day.