ARMOUR Residential REIT, Inc.
Q2 2019 Earnings Call Transcript

Published: 25 Jul 2019

[Operator:]

Greetings, and welcome to the ARMOUR Residential REIT second-quarter 2019 earnings conference call. As a reminder, this conference is being recorded, Thursday, July 25, 2019. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

[Jim Mountain:]

Thank you, Edison, and thank you, all, for joining our call to discuss ARMOUR's second-quarter 2019 results. This morning, I'm joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and our CIO and Chief Operating Officer, Mark Gruber. By now, everyone has accessed ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website, www.armourreit.com. This conference call may contain statements that are not mere recitations of historical fact and, therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

[Scott Ulm:]

Thanks, Jim. Good morning. Fears of the global recession reverberated throughout the world in the second quarter of 2019 as sharp declines in global trade volumes and manufacturing data further dimmed the economic outlook. May 2019 produced a risk-off mode for stocks and spread products accompanied by a sharp rally in treasury bills. A potential market meltdown similar to the fourth quarter of last year forced the fed to abandon its on-hold position in favor of a more flexible monetary policy to combat plunging inflation expectations and shaky real growth. The fed's verbal commitment is to the global risk markets. However, the spread between three-month LIBOR and the 10-year treasury yield remains firmly in negative territory, signifying that actions speak louder than words. Therefore, we anticipate the Federal Reserve Bank will follow up with at least a 50-basis-points decrease in overnight borrowing costs by the year's end to help normalize the yield curve.

[Operator:]

Our first question comes from the line of Douglas Harter with Credit Suisse. Please proceed.

[Douglas Harter:]

Thanks. I was hoping you could talk about the decision to reduce the dividend in the quarter kind of in light of core earnings still being kind of well above the prior dividend rate and your commentary -- so I think I heard you say that you expect relative stability in earnings.

[Jeff Zimmer:]

Hey, Doug, it's Jeff. Good morning.

[Douglas Harter:]

Good morning.

[Jeff Zimmer:]

So let me talk about a couple of things. A number of the research reports came out talking about ARMOUR and some of the peers, some of which are much larger capital than us, cutting dividends. I would note, the other firms cut the dividends in Q2. We remained at $0.19 throughout Q2, and that's certainly not clear on all the research reports that we and the board read. So we maintained a higher dividend rate as well as a higher coverage, as we just noted, $0.63 versus paying out $0.57. However, as prepayments increased, the amount of amortization expense increased quite a bit. And the funding rates, despite the fact that there is a certain -- almost certain feeling for a Federal Fund's rate cut, did not lower themselves. So as a result, today you have a fed funds seven to eight basis points above LIBOR, and you have prepayment rates that are still high. So we saw that coming with our portfolio characteristics and we want to cut the dividend to a point that reflects the amount that we believe we're earning. So let's think about Q3. We would like analysts to think about Q3 in terms of what we're paying out is what we believe we're earning. So if we increase the dividend in the future quarters and prepayments come in, fed -- funding rates go down, then that will say to the world that, "Hey, we think we're going to earn that." If we keep the dividend rate at $0.17, that's where we think we're earning. So that's where we are right now. And with that, I noticed on some of your comments you wrote overnight, which I'm very appreciative of, let's talk about the power of capital management. We have redeemed the Series A as of tomorrow. So if you take those Series A off our balance sheet, our actual leverage as of tomorrow will be 9.0.

[Douglas Harter:]

I guess just to drill down on that comment that the dividend reflects kind of what you expect to earn. So I guess, if we were to look at kind of 3Q relative to 2Q, I mean, I guess, do you expect more margin compression from speed increases, more funding pressures? I guess just trying to understand kind of the -- what else is kind of the sequential pressures on earnings also kind of given the capital actions that you highlighted, which do seem positive.

[Jeff Zimmer:]

Yes, precisely on the amount of amortization expense. We expect prepayments to go up again for the month that will be revealed at the first week in August, and we expect them to be slightly up again for September. However, we expect it to recede from there due to seasonal reasonings and the fact that you've gone through a recycle -- a refinance cycle that you're going to see a little bit of burnout on. So we put the $0.17 there. Why did we stable with that based on the amortization expense that we see for the next couple of months? I just can't see prepayment rates going up in November and December and January from where we're going to see in September, which should be toward the height of the cycle.

[Douglas Harter:]

Great. Thank you.

[Jeff Zimmer:]

Thank you.

[Operator:]

The next question comes from the line of Trevor Cranston with JMP Securities. Please proceed.

[Trevor Cranston:]

Hey, thanks. Good morning. One quick follow-up on the question of prepayments and the rate of amortization for 3Q. So obviously, we can see where rebates come in for July.

[Jeff Zimmer:]

Good morning, Trevor. It's Jeff. Hey, Mark, do you want to discuss our estimates for the next couple of months relative to where -- that we've just had?

[Mark Gruber:]

Sure. So we expect in the next month here 25% or so. And then in September, up -- maybe from flat to up maybe 10% or so, and that's what we're using in our estimates based on what we see in our portfolio characteristics. And like Jeff said, from there, we think things will moderate. But again, it all is going to depend on what the curve looks like and what the fed does.

[Jeff Zimmer:]

Trevor, one thing I would note is our exposure to adjustable rate-ons is de minimis. So as a result, when you see these recycle -- refinance cycles going on, you see a lot of ARMs prepay very heavily because people want to lock in low longer-term rates. So that's not applicable to us. So what you'd be seeing for us is just taking part of our portfolio that's not as well protected, which is like 25%, and you're seeing just some refinance cycle through there.

[Trevor Cranston:]

Okay. And on the funding side, I think you guys made a comment that your repo rates haven't declined quite at the pace that we've seen, particularly three-month LIBOR decline so far. Do you guys have any thoughts around sort of when you would expect that relationship to normalize and what'll be the instigator for repo rates to finally start coming in a little bit?

[Jeff Zimmer:]

I suspect that after the fed meets is you'll still start seeing that down. So as a result -- let's look at this two ways. First of all, we're currently a beneficiary of that because our receiver book is substantially all OIS. So with fed funds above LIBOR, we're actually earning more money on that right now. However, to your point, our funding rates haven't dropped as much. So what we've done is we have -- because of the unique relationship that we have with BUCKLER, we're able to do a lot of short-term overnight stuff. And so we have a few billion dollars of overnight paper. So as we get closer to the potential of the fed fund's cut on the 31st of July, then we can start extending that out a little farther. So we're really positioned, where we're exactly where we want to be to benefit the most that we think we can from the expected cut in rates.

[Trevor Cranston:]

And so just to be clear, so when you guys mentioned that the new dividend level, basically, what you think you're going to earn, does that also incorporate that expectation that the fed is going to lower rates this quarter?

[Jeff Zimmer:]

It is completely correct. We believe that we will meet our $0.17 a month for the third quarter based on the fact that we expect a 25-basis-point cut in July. If you have no cut at the end of July, it will be challenging to earn $0.17 every single month this quarter.

[Trevor Cranston:]

Got you. Okay, that helps. I appreciate the comments. Thank you.

[Jeff Zimmer:]

You're welcome.

[Operator:]

The next question comes from the line of Christopher Nolan with Ladenburg Thalmann. Please proceed.

[Christopher Nolan:]

Hi. What was the per-share price that you guys repurchased shares out in the quarter? Can you share that, please?

[Jeff Zimmer:]

Jim, did we announce that?

[Jim Mountain:]

We haven't announced that. But if you do the math backwards from the -- something that rounds just barely down to 0.02 a share effect on the outstanding. It's a little bit of an algebra exercise, but you ought to be able to solve backwards for it. But we have not announced the average repurchase price.

[Christopher Nolan:]

Great. And then how are you guys looking at repurchases going forward? I was listening to the comments and it sounds like mortgage assets are fairly priced, it sounds like. Your leverage ratios are fairly high at the moment, but you have this large repurchase authorization and your stock price seems to be attractive for repurchases. So how do you balance out everything between earnings and supporting book value? What was the thinking there, please?

[Jeff Zimmer:]

So well, a couple of thoughts. The nine times leverage we are today, that would be under our peer group actually -- or particularly, the two larger peers that have at least one more full term of leverage. So I don't think that's an outlier there. We have been -- going to use the word reporting some cash because we have to go ahead tomorrow and pay down the $55 million of the Series As, and we'll see how things -- the result of buying back the Series As, see mortgage spreads and the funding rates look as the Federal Reserve gets closer to their meeting and then subsequent to the meeting. And based on all of those components, then we'll take a look at the capital structure today. Do you want to use some cash to buy back some shares because we like -- don't like investment opportunities? Or now, hey, investment opportunities look a little better so we'd rather buy some assets and lever them up to benefit shareholders. So these things happen on a weekly basis. And you look out a month or two as we do with our board and we pencil it all out, which, okay, if this happens, we'll do this. If this happens, we'll do that. And so if the mortgage opportunity investments don't look good and our stock remains 9% or 10% under par, then you can anticipate we'll be buying back some shares.

[Jim Mountain:]

Yes. One other thing I'd like to say about that, Jeff, and the 8.625 million share authorization remains. We went to the board and increased that this last quarter, but that was -- the last time we've done that is several years ago. So this share authorization is intended to give us some dry powder for an extended period of time to be able to adapt to market circumstances as they evolve over the long term. This is not something that I -- from my own personal corner of the office, think that the board intended us to go spend immediately.

[Jeff Zimmer:]

Hey, Chris, I would also note, in a modestly underappreciated way, the management team has spent after-tax millions of dollars buying ARMOUR stock over the last quarter, a few million dollars, I believe, if you take a look at the press release. And I note the two larger peers in our group spent about the same amount of money as well. So if you see the management team is taking after-tax millions of dollars each buying stock and you see the reduction in the Series A and you see the company buying back stock, that means that people are very comfortable with the capital structure.

[Christopher Nolan:]

Great. And final question. Based on your comments, is it fair to say that we should expect an increase in leverage ratios in the second half of the year?

[Jeff Zimmer:]

No, that's not true at all. We just reduced actually recently.

[Christopher Nolan:]

Okay. Okay, great. Thank you.

[Jeff Zimmer:]

Thank you.

[Operator:]

The next question comes from the line of Matthew Howlett with Instinet. Please proceed.

[Matthew Howlett:]

Hey, guys. Thanks for taking my question. Jeff, you have been through a lot of cycles here and have seen the balance sheet duration gap increase and that helped, obviously -- helping book value here in July. Where do you feel -- I think you said you'd expect 50 bps by the end of the year. I think the market's pricing a little bit more. And in fact, it may even go as high as 100 bps a year from now. I mean where do you think you could take the duration gap to if the market is right where the fed is going?

[Jeff Zimmer:]

Well, what we've learned over the last few years is that we need to actually keep a positive duration. So we've been using treasuries intermediately to maintain that duration. I would guess that our duration -- actual balance sheet duration has ranged from 0.3 0.75 over the last 60 days I think would be a good rate. We want to keep our balance sheet duration there. Now true duration gap, we don't actually include our liabilities for a repo on that. So if you want to look at the average life of our assets, it's always going to well exceed the average life of our repo liabilities. Is that helpful?

[Matthew Howlett:]

Yes, that's helpful. So to the extent this -- I mean if the fed does go more, that you're -- than you're expecting, you're going to be in a position to benefit from it?

[Jeff Zimmer:]

We believe greatly so, and that's why we're keeping a large amount on overnights. And honestly, once again, that's the power of having our own broker-dealer, BUCKLER, because a lot of the other guys do not want to do overnights in large amounts, okay? We're able to do that. And if we see the world change, we can move very quickly.

[Matthew Howlett:]

Right. Got it. And then you guys have always done a good job managing convexity and looking at opportunities. I think you sort of said that -- I mean, a lot of guys out there are saying they're finding opportunities in certain coupons and maybe not pay up. I mean are you just sort of waiting to see the prepayment landscape in the back of the year to take advantage of that? Or it's just -- I can tell from your comments that there's not an incredible amount of opportunity you're seeing right now across the coupon stack.

[Jeff Zimmer:]

But you started your comments by saying we've been through a number of these cycles and we have been through a lot of these cycles. I've been in the business for 35 years. So we are waiting. And always, through these cycles become -- opportunities do present themselves. We don't think they're there today. So don't anticipate our leverage going up. The only reason we'd go up a little bit is if the book value came off a little bit because that's your denominator effect, all right? But we're not on purpose trying to increase leverage right here. We do think that after the fed meets, and we see where they're trying to go cyclically, that you're going to have mortgages loosen up and provide some opportunities. If you look at pay-ups, in our board meeting the other day, we're looking at a lot of assets that would pay 12 and 14, 30 seconds for are trading 60, 30 seconds over TBAs now. They're very rich. And there's no value there. But we're not going to sell them because we have investors who appreciate the fact we maintain dividends every quarter. So that's the way we're looking at stuff. DUS, on a levered basis, which is one of our favorite asset classes, is really tight. Don't see a lot of opportunities there. We think ARMs are a disaster right now. They're going to prepay very heavily. And I can see the book value of one of the peers that owns a lot of ARMs, their book value got -- went down quite a bit. That's because the market's reappraising the value in that asset class. I would expect those values to go a little lower before there's something that we want to look at. But these things always change and they oftentimes change when you just don't expect it. So we're going to keep some dry powder. As I said, if we don't fit that asset, we'll buy back some more stock. But there will be an opportunity. We're just going to be patient. We're not going to force it.

[Matthew Howlett:]

Yes. Makes a lot of sense. I appreciate the conservatism. Thanks for taking my questions.

[Jeff Zimmer:]

Thank you.

[Operator:]

And there are no further questions. I'll now turn the call back for any closing remarks.

[Jeff Zimmer:]

Well, thank you very much, everybody.

[Jim Mountain:]

Thank you, everyone for…

[Jeff Zimmer:]

Oops. Sorry, Jim. Please go ahead.

[Jim Mountain:]

No. I was just going to thank everybody for their participation this morning. We are around the office. So if anybody has questions throughout the quarter, always give us a call. We'll try and get back to you instantly or by the end of the day. And we always enjoy having an opportunity to have dialogue with people that are following our stock. So until next time. We'll see you then.

[Operator:]

That does conclude the conference call for today and we thank you for your participation and ask that you please disconnect your lines.