UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2004
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 001-32026
SUNSET FINANCIAL RESOURCES, INC.
(Exact name of registrant as specified in its governing instruments)
Maryland 16-1685692
(State or other jurisdiction (IRS Employer Identification Number)
of incorporation or organization)
10245 Centurion Parkway, Third Floor
Jacksonville, FL 32256
(Address of principal executive offices, Zip Code)
Registrant's telephone number, including area code: (904) 425-4099
(Former name, former address and former fiscal year,
if changed since last report)
4231 Walnut Bend
Jacksonville, FL 32257
(Former address)
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
(1) Yes [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes [X] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock ($.001 par value) 10,450,000 as of April 30, 2004
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENT OF OPERATIONS
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
CONSOLIDATED STATEMENT OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
Item 3 Quantitative and Qualitative Disclosures About
Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
Index
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2004
and December 31, 2003 1
Consolidated Statement of Operations for the
three months ended March 31, 2004 2
Consolidated Statement of Comprehensive Income
for the three months ended March 31, 2004 3
Consolidated Statement of Shareholders' Equity
for the three months ended March 31, 2004 4
Consolidated Statement of Cash Flows for the
three months ended March 31, 2004 5
Notes to the Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 20
Item 4. Controls and Procedures 20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 21
Item 2. Changes in Securities and Use of Proceeds 21
Item 3. Defaults Upon Senior Securities 21
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 5. Other Information 21
Item 6. Exhibits and Reports on Form 8-K 21
SIGNATURES 22
EXHIBIT INDEX 23
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Sunset Financial Resources, Inc
Consolidated Balance Sheets)
(amounts in thousands)
March 31, December 31,
2004 2003
--------- ------------
(unaudited)
Assets
Mortgage assets
Hybrid adjustable rate residential mortgages $ 149,996 $ --
Fixed rate residential mortgages 6,144 --
Commercial mortgages 11,500 --
--------- -----
Total mortgage assets 167,640 --
--------- -----
(15) --
Net mortgage assets 167,625 --
Cash and cash equivalents 49,430 44
Interest receivable 577 --
Fixed assets, net 662 16
Deferred offering costs -- 255
Hedging assets 49 --
Other 138 --
--------- -----
Total assets $ 218,481 $ 315
========= =====
Liabilities
Whole loan financing facilities $ 100,423 $ --
Notes payable to stockholders -- 145
Accrued liabilities 616 143
--------- -----
Total liabilities 101,039 288
Commitments -- --
Shareholders' equity
Preferred stock, $.001 par value,
authorized 50,000,000; no shares outstanding -- --
Common stock, $.001 par value, authorized
100,000,000 shares; 10,450,000 and
466,667 outstanding, respectively 10 1
Additional paid in capital 118,948 48
Accumulated other comprehensive income 49 --
Retained earnings (1,565) (22)
--------- -----
Total shareholders' equity 117,442 27
--------- -----
Total liabilities and shareholders' equity $ 218,481 $ 315
========= =====
See Notes to Consolidated Financial Statements.
1
Sunset Financial Resources, Inc
Consolidated Statement of Operations (Unaudited)
(amounts in thousands, except per share amounts)
Three Months Ended
March 31, 2004
------------------
Interest income $ 44
Interest expense 32
-----------
Net interest income 12
Provision for loan losses 15
-----------
Net interest income after provision (3)
Operating expenses
Salaries and employee benefits 902
Professional fees 224
Other 414
-----------
Total operating expenses 1,540
-----------
Net income (loss) $ (1,543)
===========
Basic earnings per share (.73)
Diluted earnings per share (.85)
Weighted average basic shares 2,112,271
Weighted average diluted shares 2,117,922
See Notes to Consolidated Financial Statements.
2
Sunset Financial Resources, Inc
Consolidated Statement of Other Comprehensive Income (Unaudited)
(amounts in thousands)
Three Months Ended
March 31, 2004
------------------
Net income (loss) $(1,543)
Other comprehensive income
Unrealized gain on hedging instruments 49
-------
Comprehensive income $(1,494)
=======
See Notes to Consolidated Financial Statements.
3
Sunset Financial Resources, Inc
Consolidated Statement of Shareholders' Equity (Unaudited)
(amounts in thousands)
================================================================================================================================
Common Paid in Capital Other Comprehensive Retained Total
Stock Income Earnings
- --------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 $ 1 $ 47 $ -- $ (22) $ 26
Proceeds of initial public offering 9 118,643 118,652
Issuance of stock warrants 191 191
Amortization of restricted stock
awards 61 61
Amortization of stock option awards 6 6
Unrealized gain on hedging
instruments 49 49
Net income (loss) (1,543) (1,543)
-----------------------------------------------------------------------------------
Balance at March 31, 2004 $ 10 $ 118,948 $ 49 $(1,565) $117,442
================================================================================================================================
See Notes to Consolidated Financial Statements.
4
Sunset Financial Resources, Inc
Consolidated Statement of Cash Flows (Unaudited)
(amounts in thousands)
Three months ended
March 31, 2004
------------------
Operating activities
Net income (loss) $ (1,543)
Adjustments to reconcile net income to net
cash provided from operations
Stock based compensation expense 258
Provision for credit losses 15
Depreciation and amortization of fixed assets 7
Increase in accrued interest (577)
Increase in other assets (138)
Increase in accrued liabilities 473
Decrease in deferred offering costs 255
---------
Net cash used in operating activities (1,250)
Investing activities
Loan purchases (167,640)
Purchase of fixed assets (654)
---------
Net cash used in investing activities (168,294)
Financing activities
Net borrowing under whole loan financing facilities 100,423
Net payments made on shareholder notes (145)
Net proceeds from stock offering 118,652
---------
Net cash provided by financing activities 218,930
Net increase in cash 49,386
Cash and cash equivalents at beginning of period 44
---------
Cash and cash equivalents at the end of the period $ 49,430
=========
See Notes to Consolidated Financial Statements.
5
Sunset Financial Resources, Inc
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note A - ORGANIZATION
Sunset Financial Resources, Inc. (the "Company") was incorporated in Maryland on
October 6, 2003 under the name of Sunset Capital Investments, Inc. but had
limited operations until the first quarter of 2004.
On November 17, 2003, Sunset Capital Investments, Inc. filed amended articles of
incorporation to change its name to Sunset Financial Resources, Inc. and to
change the number of authorized shares from 15,000,000 to 50,000,000 shares of
preferred stock and from 50,000,000 to 100,000,000 shares of common stock.
On November 28, 2003, the Company executed stock exchange agreements with its
founding stockholders whereby the 1,999,400 shares of Sunset Capital
Investments, Inc. issued at formation were exchanged for 466,667 shares of
Sunset Financial Resources, Inc.
On December 5, 2003, the Company granted 20,000 shares of restricted stock to
its advisory board member. The shares vest one year from the date of completion
of the Company's initial public offering and will be reflected as issued and
outstanding for accounting purposes when vested.
On March 17, 2004, the Company completed its Initial Public Offering of
10,000,000 shares of common stock. In conjunction with the issuance of stock to
the public, founding stockholders surrendered 16,667 shares of stock, stock
options on 262,000 shares of stock were granted to officers and directors, and
warrants were issued to the Sapphire Group to acquire up to 233,000 shares of
common stock.
Note B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Our books and records are maintained on the accrual basis of accounting in
accordance with accounting principles generally accepted in the United States
and include all of the Company's accounts and its 100% owned subsidiary, SFR
Subsidiary, Inc. The Company consolidates all entities in which it has a
controlling interest as determined by a majority ownership interest in the
common stock of such entities or the ability to exercise control and
consolidates any variable interest entities for which it is the primary
beneficiary. The financial statements reflect all adjustments management
considers necessary, and all of these adjustments are of a normal and recurring
nature. Our fiscal year end is December 31 of each year.
Use of Estimates
The presentation of the financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from these
estimates.
Deferred Offering Costs
As of December 31, 2003 certain costs incurred, which were directly attributable
to our initial public offering, were deferred and subsequently charged against
the proceeds of the offering.
6
Profit and Loss Allocations and Distributions
As a REIT, the Company intends to declare regular quarterly distributions in
order to distribute substantially all of our taxable income to stockholders each
year.
Investment Securities
The Company anticipates that at times it will have an investment securities
portfolio made up of mortgage-backed securities or other types of securities.
The mortgage backed securities will be securities that qualify as REIT assets.
Proceeds of stock or debt offerings may be invested in other securities until
the capital can be deployed into mortgage related assets.
In most cases, investment securities will be held as Available for Sale with any
mark to market adjustment shown in other comprehensive income.
Loans
The Company invests in mortgage loans and maintains a loan portfolio on its
balance sheet. These loans will be carried at historical cost with any initial
premium or discount being amortized as a yield adjustment. The Company will
primarily invest in hybrid adjustable rate mortgage loans (ARM's). These are
loans that have an initial fixed term with the remaining term being floating.
The initial fixed period will range from one to ten years.
Retained Interests in Loan Securitizations
The Company anticipates using securitization as a method of funding its mortgage
loans. Securitization will either be used to create investment securities that
are held in the Available for Sale portfolio or to create Collateralized Debt
Obligations that are shown as secured borrowings. For secured borrowings, both
the loans and the debt will be reflected in the balance sheet. In either case,
there will not be gain on sale accounting treatment.
Retained interests in securitizations (other than investment securities) will be
accounted for as Available for Sale securities and carried at estimated fair
value, with unrealized gains or losses included in shareholders' equity
(accumulated other comprehensive income or loss). The Company is not aware of an
active market for the purchase and sale of these retained interests at this
time; accordingly, we will estimate the fair value of the retained interest by
calculating the present value of the estimated expected future cash flows
received after being released by the securitization trust, using a discount rate
commensurate with the risk involved. The cash flows being discounted will be
adjusted for estimated net losses due to defaults or prepayments of the
underlying loans.
Changes in the fair value of the retained interests resulting from changes in
the timing of cash flows to be received or changes in market interest rates will
be adjusted through other comprehensive income in shareholders' equity.
Reductions in the estimated aggregate cash flows to be received, caused by
defaults or prepayments or the timing of expected future cash flows that result
in a reduction to the fair value of the retained interests, will be considered
an other than temporary impairment and will be recognized through a charge to
expense in that period.
Accounting for Stock Compensation
The Company accounts for stock based awards in accordance with the fair value
recognition provisions of SFAS Statement No. 123 "Accounting for Stock-Based
Compensation" (FAS 123).
The Company records an expense for the fair value of stock based awards. Awards
to non-employee service providers will be measured on the earlier of (1) the
performance commitment date or (2) the date the services required under the
arrangement have been completed. The fair value will be measured using the
Black-Scholes option pricing model over the contractual term of the award. If
performance of services has already occurred, expense is recorded based on the
fair value on the date of grant.
7
Interest on Loans
Interest will be accrued monthly on outstanding principal balances unless
management considers the collection of interest to be uncertain. The Company
generally considers the collection of interest to be uncertain when loans are
contractually past due three months or more.
Hedging Activities
The Company enters into interest rate swap transactions to extend the duration
of its short-term liabilities funding mortgage related assets. These swaps are
accounted for as cash flow hedges under Statement of Financial Accounting
Standards No. 133 "Accounting for Derivative Instruments and Hedging
Activities", as amended (SFAS No. 133). The fair value of the hedge is recorded
on the balance sheet, with the effective portion of the hedge being carried in
other comprehensive income in shareholders' equity. Any ineffectiveness is
recognized through the income statement.
The Company may enter into certain other transactions, including short sales,
purchases of treasury options, mortgage-backed securities and futures, interest
rate swaps, caps and floors to mitigate the effect that changes in interest
rates have on the fair value of its fixed rate loan and mortgage-backed
securities portfolios. Periods of rising interest rates will generally decrease
the fair value of a loan or mortgage-backed securities portfolio.
Income Taxes
The Company will elect to be taxed as a REIT under Sections 856 through 860 of
the Internal Revenue Code and, upon the election being made, will be taxed as
such beginning with the taxable year ending December 31, 2004. To qualify as a
REIT, the Company must meet certain organizational and operational requirements,
including a requirement to currently distribute at least 90% of ordinary taxable
income to stockholders. As a REIT, the Company generally will not be subject to
federal income tax on taxable income that the Company distributes to its
stockholders. If the Company fails to qualify as a REIT in any taxable year, it
will then be subject to federal income taxes on taxable income at regular
corporate rates starting with that year and will not be permitted to qualify for
treatment as a REIT for federal income tax purposes for four years following the
year during which qualification is lost unless the Internal Revenue Service were
to grant relief under certain statutory provisions.
Allowance for Loan Losses
The Company will provide an allowance for loan losses related to its loan
portfolio. Loan loss provisions will be based on an assessment of numerous
factors affecting the portfolio of mortgage assets including, but not limited
to, current and projected economic conditions, delinquency status, credit losses
to date on underlying mortgages and any remaining credit protection. Loan loss
provision estimates are reviewed periodically and adjustments are reported in
earnings when they become known.
Fixed Assets
The Company has capitalized costs related to long lived assets to be used in the
business. These assets will be depreciated or amortized over their estimated
useful lives.
8
NOTE C - MORTGAGE ASSETS
The Company completed its initial purchase of residential loans on March 30,
2004. The balances by original fixed period are in the following table.
================================================================================
Initial Fixed Term Loan Balance Premium Book Value
- --------------------------------------------------------------------------------
Fixed rates 5,976 168 6,144
3 year fixed 13,672 233 13,905
5 year fixed 98,685 2,831 101,516
7 year fixed 33,797 778 34,575
- --------------------------------------------------------------------------------
Total 152,130 4,010 156,140
================================================================================
After the initial fixed term, the hybrid ARMs reprice with the following
indexes: six month LIBOR (33%), one year LIBOR (36%), and the one-year constant
maturity treasury (31%).
None of the residential mortgage loans were delinquent as of the end of the
first quarter.
In addition to residential mortgage loans, the Company invests in commercial
mortgage bridge loans. As of the end of the first quarter, the Company had
closed and funded one bridge loan in the amount of $11.5 million. This loan is
secured by a hotel in Anaheim, CA, has a remaining term of six months, and bears
interest at a rate of 10%.
NOTE D - CASH AND CASH EQUIVALENTS
As of March 31, 2004, the Company had $49.4 million in cash and equivalents.
This included both interest bearing and non-interest bearing bank balances.
These balances exceed the liquidity requirements required under the warehouse
line of credit and will be utilized to fund additional loans.
NOTE E - HEDGING
As of March 31, 2004, the Company had hedged a portion of its interest rate risk
by entering into interest rate swaps (designated as cash flow hedges) to extend
the duration of its short term borrowings. No ineffectiveness was recorded
during the period ended March 31, 2004. Total notional outstanding at the end of
the first quarter was $68 million with a fair market value of $49 thousand.
================================================================================
(in thousands) Notional Avg Fixed Rate
- --------------------------------------------------------------------------------
Maturing in less than one year --
Maturing between one and two years 63,000 1.79%
Maturing between two and five years 5,000 3.04%
Maturing in over five years --
- --------------------------------------------------------------------------------
NOTE F - DEBT
The Company has a $250 million warehouse line of credit that is used to finance
the purchase of residential mortgage loans. This facility bears interest at
LIBOR plus 1.125% and includes a 0.25% facility fee.
As of March 31, 2004, $100.4 million was outstanding under this facility.
9
All shareholder notes incurred in connection with the Initial Public Offering
(those outstanding at December 31, 2003 and the advances made during the first
quarter prior to the receipt of the initial public offering proceeds) were
repaid during the quarter.
NOTE G - SHAREHOLDERS' EQUITY
On March 17, 2004, the Company priced its initial public offering of 10,000,000
shares of common stock. The net proceeds of $118.7 million are reflected in
shareholders' equity.
Diluted earnings per share assumes the recognition of $248 thousand of expense
related to 25,000 shares of restricted stock that will be recognized over the
remaining vesting period, and that this dollar amount will be used to purchase
19,349 shares of treasury stock as of the beginning of the period.
NOTE H - STOCK-BASED INCENTIVE COMPENSATION PLAN
The Company adopted the 2003 Share Incentive Plan which permits the granting of
stock options, dividend equivalent rights and restricted stock awards. The terms
of the plan stipulate that the exercise price of the options may not be less
than fair market value of the stock on the date the options are granted. The
Company has reserved shares of common stock for issuance under this plan equal
to 1,045,000 shares.
Options granted vest according to their terms and expire ten years from the date
of grant. The Company granted options to purchase 262,000 shares of common stock
to executive officers and independent directors of the Company effective on the
closing of the our initial public offering and exercisable at the initial
offering price. An expense was recorded based on the fair value of the options
on the grant date in accordance with FAS 123 measured using the Black-Scholes
option pricing model over the options expected life and amortized over the
vesting period of three years. The options were valued at $.82 per share using a
stock price volatility of 30%, an expected life of ten years, a dividend yield
of ten percent, and a risk free rate of return of 4.16%.
The Company also granted warrants to purchase 233,000 shares of common stock to
Sapphire Advisors Group (Sapphire), a founding shareholder. The warrants were
granted to Sapphire in connection with its role in assisting the Company from
and after the date of its formation. Sapphire assisted in the formation of the
Company and its taxable subsidiary, the recruiting of officers and directors,
identifying underwriters, and identifying and negotiating credit facilities.
These warrants were granted effective on the closing of our initial public
offering and are exercisable at the initial offering price. The warrants were
fully vested at the date of grant and will expire ten years from the date of
grant. An expense was recorded for the warrants fair value in accordance with
FAS 123 measured using the Black-Scholes option pricing model. The warrants were
valued at $.82 per share using a stock price volatility of 30%, an expected life
of ten years, a dividend yield of ten percent, and a risk free rate of return of
4.16%.
On December 5, 2003, the Company granted 20,000 shares of restricted stock to
its sole advisory board member. The shares vest one year from the date of the
initial public offering, March 17, 2004, and will be recorded at fair value,
which was based on the value at the time of the initial public offering ($13 per
share). The shares will be reflected as outstanding when vested, and shares were
purchased by the recipient at par value.
Upon completion of the Initial Public Offering, the Company granted 5,000 shares
of restricted stock to an officer of the Company. The shares vest one year from
the date of grant and were valued at $13 per share based on the initial public
offering price of the stock. The shares will be reflected as outstanding when
vested, and vested shares may be purchased by the recipient at par value.
NOTE I - INCOME TAXES
The Company will elect to be taxed as a REIT commencing with the taxable year
ending December 31, 2004. For the tax year ended December 31, 2003 the Company
was taxed as a C Corporation. The Company had a net operating loss carryforward
of approximately $21,000 for which a valuation allowance has been recorded for
the entire deferred tax
10
asset. Due to the election to be taxed as a REIT in future years, the Company
does not expect to be able to utilize the NOL carry forward prior to expiration
in 2023.
NOTE J - SUBSEQUENT EVENTS
The Company has entered into a contract with Blackrock Solutions ("Blackrock")
to receive risk management systems and analytical tools for the next three
years. Blackrock Solutions is the recognized leader in the risk management
services and systems business, especially with regard to financial institutions.
Under the agreement, Blackrock will provide services in a "risk management
service bureau" capacity, which includes daily risk position assessment and
reporting. Blackrock will also provide the use of their state of the art
analytical system (with prepayment and interest rate models) to enable the
Company to quickly and accurately analyze investment opportunities and hedging
decisions. Management believes that the contract with Blackrock Solutions will
provide the flexibility to effectively pursue investment objectives and focus on
our core business.
The Company has also entered into a forward commitment to purchase, at
approximately par, $85 million in seven year interest only hybrid ARM loans for
June 21, 2004 settlement. These loans, which are subject to normal and customary
caps, have an average net loan rate of 4.61%, an average loan to value ratio of
70%, and an average FICO score of 730.
As a part of interest rate risk management, the Company entered into a series of
pay fixed interest rate swap agreements to increase the duration of its
forecasted short term borrowings program. Including the swaps entered into
before the end of the first quarter, the total notional amount of outstanding
swaps as of April 30, 2004 was $183.8 million. The table below outlines the
maturities and rates of the swaps.
================================================================================
(in thousands) Notional Avg Fixed Rate
- --------------------------------------------------------------------------------
Maturing in less than one year --
Maturing between one and two years 63,000 1.79%
Maturing between two and five years 40,000 3.26%
Maturing in over five years 80,800 3.94%
================================================================================
In addition, the Company has closed and funded three additional commercial loans
for a total of $28.3 million bringing the total funded commercial loan portfolio
to $39.8 million. The loans have a weighted average interest rate of 10.29% and
have a weighted average term of 10.79 months.
11
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward Looking Statements
Certain statements in this Form 10-Q constitute "forward-looking statements" and
involve risks, uncertainties and other factors, which may cause the actual
performance of Sunset Financial Resources, Inc. to be materially different from
the performance expressed or implied by such statements. These risks include our
failure to successfully execute our business plan, gain access to additional
financing, the availability of additional loan portfolios for future
acquisition, continued qualification as a REIT, the cost of capital, as well as
the additional risks and uncertainties detailed in the our periodic reports and
registration statements filed with the Securities and Exchange Commission.
Corporate Governance
We pride ourselves on maintaining an ethical workplace in which the highest
standards of professional conduct are practiced. Accordingly, we would like to
highlight the following facts relating to corporate governance:
o Our Board of Directors consists of a majority of independent
directors. The Audit, Nominating/Corporate Governance and
Compensation Committees of the Board of Directors are composed
exclusively of independent directors.
o All long-term incentive awards are expensed in our consolidated
income statements and are fully disclosed in our financial reports.
o We have adopted Corporate Governance Guidelines that cover a wide
range of business practices and procedures that apply to all of our
employees, officers and directors.
o We have adopted a Code of Business Conduct and Ethics that covers a
wide range of business practices and procedures, that apply to all
of our employees, officers and directors, and that foster the
highest standards of ethics and conduct in all of our business
relationships.
o We have implemented an Insider Trading Policy that prohibits any of
the directors or officers of the Company or any director, officer or
employee from buying or selling our stock on the basis of material
nonpublic information, and prohibits communicating material
nonpublic information to others.
Our Internet website address is www.sunsetfinancial.net. We will make available
free of charge, through our Internet website, our annual report on Form 10-K,
our quarterly reports on Form 10-Q, our current reports on Form 8-K, ownership
reports on Forms 3, 4 and 5 and any amendments to those reports that we file or
furnish pursuant to Section 13(a) or 15(d) of the Securities Exchange
12
Act of 1934 as soon as reasonably practicable after we electronically file such
material with, or furnish it to, the Securities and Exchange Commission (the
"SEC").
Our website also includes our Code of Business Conduct and Ethics, Corporate
Governance Guidelines and the charters of the Audit Committee,
Nominating/Corporate Governance Committee and Compensation Committee of our
Board of Directors. These documents are also available in print to anyone who
requests them by writing to us at the following address: 10245 Centurion Parkway
North, Suite 305, Jacksonville, FL. 32256. Please note that the reference to our
website address is an inactive textual reference made only for purposes of
complying with SEC rules.
General
We are a self-managed REIT that was formed in October 2003 to acquire a
portfolio of high quality residential mortgage loans and commercial mortgage
bridge loans (including loans that we will own jointly with others) in the
United States. We will derive our revenues primarily from interest on loans
acquired with our equity capital and borrowed funds. Our principal business
objective is to generate net income for distribution to our stockholders from
the spread between interest income on our mortgage assets and the costs of
financing the acquisition of these assets. We expect that this spread, net of
operating expenses, will provide both operating capital and distributable
income.
Our fiscal year end is December 31. We intend to elect to be taxed as a REIT for
federal tax purposes commencing with our taxable year ending December 31, 2004,
thereby generally avoiding federal income taxes on our taxable income that we
distribute currently to our stockholders.
Critical Accounting Estimates
The financial statements reflect all adjustments we consider necessary, and all
of these adjustments are of a normal and recurring nature.
Although we invest in high quality residential and commercial mortgage bridge
loans, we have established an allowance for loan losses and a provision that
reflects the estimated losses in the portfolios. The allowance is evaluated on a
quarterly basis and any necessary adjustments are made at that time.
We record expenses for the estimated value of stock based awards for both
employees and non-employees. These awards are valued using the Black-Scholes
option pricing model. This model requires assumptions related to stock price
volatility, dividend yield, expected option life, and a risk free rate of
return.
We also make estimates related to our hedging transactions that we enter. For
our cash flow hedges of forecasted transactions, we have estimated the level of
short term financing needed in the future.
Financial Condition
During the first quarter of 2004, we completed our initial public offering. The
offering of 10 million shares was priced at $13 per share on March 17, 2004 and
the proceeds (net of underwriting
13
fee, attorney's fees, accounting fees, and printing cost) were subsequently
received. After deducting additional offering related costs, the net increase to
stockholders' equity was $118.7 million.
The net proceeds were used to repay total outstanding shareholder loans of $190
thousand, acquire fixed assets of $654 thousand, and to purchase mortgage
assets. We purchased three pools of residential mortgage loans on March 30, 2004
with outstanding principal balances of $152.1 million for a total purchase price
of $156.7 million that included accrued interest and a premium to par. The total
premium paid for these loans was $4.0 million. The three pools of residential
mortgage loans consisted of unpaid principal balances of $86.6 million from
JPMorgan, $58.6 million from Morgan Stanley, and $6.9 million from Sunset
Mortgage. In addition to residential loans, we purchased an $11.5 million
commercial mortgage bridge loan at par on March 30, 2004.
Our focus is on acquiring high quality hybrid ARM loans. The initial loans
purchased were 96% hybrid ARMs and 4% fixed rate. The table below shows the
initial fixed rate period for the loans purchased.
============================================================
Loan Type Percent
------------------------------------------------------------
Three year fixed 53%
Five year fixed 16
Seven year fixed 27
Subtotal 96
Fixed for term 4
------------------------------------------------------------
Total 100%
============================================================
The hybrid ARMs reprice based on the following indexes after the initial fixed
rate term: 36% one year LIBOR, 33% six month LIBOR, and 31% the one-year
constant maturity treasury.
We are committed to acquiring high quality loans. The average loan to value
ratio was 72% with a weighted average FICO score of 720.
The geographic distribution and property types for the loans are in the
following table.
================================================================================
Geographic Property types
- --------------------------------------------------------------------------------
California 33.0% Single family 66.8%
New Jersey 8.7 Planned unit development 23.4
New York 7.7 Condominium 7.3
Florida 7.6 2-4 family 2.5
Virginia 4.5 -----
Other(32 states) 38.5 Total 100.0%
-----
Total 100.0%
================================================================================
In order to complete these loan purchases, we used the net proceeds of the stock
offering and borrowings of $100.4 million under a warehouse line of credit. The
warehouse line of credit was
14
closed on March 18, 2004 and has a committed capacity of $250 million. See
"Liquidity and Capital Resources" for additional information on the warehouse
line of credit.
On March 31, 2004 we had $49 million in cash and cash equivalents. These
balances were maintained in available balances to fund the remaining commercial
mortgage bridge loans that we had committed to purchase prior to the initial
public offering. An additional $28.3 million of commercial mortgage bridge loans
were funded through April 30, 2004.
Results of Operations
We recorded a net loss of $1.5 million for the first quarter of 2004. This loss
is attributable to operating expenses for the entire quarter (operations began
in October 2003) while revenue generating assets were not acquired until March
30, 2004.
Net interest income totaled $12 thousand and consisted of revenue of $44
thousand and expense of $32 thousand. The net interest income came from the
short term investment of the offering proceeds and the accrued interest for one
day on the purchased mortgage loans offset by the cost of borrowing under the
warehouse line of credit. Interest expense also includes the accrued net
interest payment on our interest rate swaps associated with short-term
borrowings.
Although we focus on high quality mortgage related assets, a provision for loan
losses has been recorded. The provision (and related allowance for loan losses)
totaled $15 thousand for the period ended March 31, 2004. Based on the asset
quality, the initial provision rates have been set at an annual rate of 10 basis
points on residential loans and 25 basis points on the commercial mortgage
bridge loans. This provision rate and the related allowance will be evaluated on
a quarterly basis to insure that, in management's opinion, the allowance is
adequate for losses in the portfolio.
Operating expenses for the quarter totaled $1.5 million. The components of
expense are $902 thousand for salaries and employee benefits, $224 thousand for
professional fees, and $414 thousand of other expenses. Included in this are
nonrecurring expenses of approximately $538 thousand, consisting of $200
thousand in bonus compensation, $147 thousand in relocation, and $191 thousand
in expense related to the warrants issued to the Sapphire Group. On a going
forward basis, expenses will increase for the build out of the operational
infrastructure that was begun in the first quarter. These operational expenses
are expected to add $600 thousand to quarterly expenses.
Liquidity and Capital Resources
We manage liquidity to ensure that we have the continuing ability to maintain
cash flows that are adequate to fund operations on a timely and cost-effective
basis. On March 31, 2004, we had liquidity of $55.2 million, consisting of
eligible ARM assets and cash and cash equivalents. We believe that our liquidity
level as of March 31, 2004 fully meets our current operating requirements.
Our primary sources of funds for the quarter ended March 31, 2004 consisted of
cash and our whole loan financing facility. In the future, we expect our primary
sources of funds to include cash and cash equivalents, reverse re-purchase
agreements, whole loan financing facilities, principal and interest payments
from ARM assets and the issuance of collateralized debt obligations.
15
The whole loan financing facility has a committed borrowing capacity of $250
million and matures in March 2005. The interest rate on the whole loan financing
facility is indexed to one-month LIBOR and is subject to daily adjustment. As of
March 31, 2004, we had $100.4 million borrowed against this whole loan financing
facility.
On March 17, 2004, we completed a public offering of 10,000,000 shares of common
stock and received net proceeds of $118.7 million. These proceeds were used to
fund the initial purchases of mortgage assets.
Our whole loan financing facility contains both financial and non-financial
covenants. Significant covenants include limitations on our ability to incur
indebtedness beyond specified levels, certain financial covenants and
restrictions on our ability to incur liens on assets. As of March 31, 2004, we
are in compliance with all financial and non-financial covenants on its whole
loan financing facility.
Market Risks
As a financial institution that has only invested in U.S.-dollar denominated
instruments, primarily residential mortgage instruments, and has only borrowed
money in the domestic market, we are not subject to foreign currency exchange or
commodity price risk, but rather our market risk exposure is limited solely to
interest rate risk. Interest rate risk is defined as the sensitivity of our
current and future earnings to interest rate volatility, variability of spread
relationships, the difference in re-pricing intervals between our assets and
liabilities and the effect that interest rates may have on our cash flows,
especially hybrid ARM portfolio prepayments. Interest rate risk impacts our
interest income, interest expense and the market value on a large portion of our
assets and liabilities.
As of March 31, 2004, mortgage loans with unpaid principal balances totaled
$152.1 million. The mortgage loans had characteristics described in the table
below. These loans were funded with a draw from our whole loan funding facility
of $100.4 million and equity capital raised in the IPO. The whole loan funding
facility is subject to re-pricing as short-term interest rates, specifically
LIBOR, change. Hence, we would be exposed to changes in short-term interest
rates. As of March 31, 2004, we had entered into two "pay-fixed" interest rate
swap agreements with a total notional amount of $68 million. These swaps
partially mitigate the effect of rising short-term interest rates by effectively
increasing the term of short term financing facilities. (see "Subsequent Events"
section for an updated discussion of hedging activity through April 30, 2004).
================================================================================
Loan Current Weighted Average Average
Type Balance Coupon LTV FICO Loan Size
- --------------------------------------------------------------------------------
15 YR Fixed 1,563,669 5.117 56.4 736 142,152
20 YR Fixed 157,540 5.682 33.2 771 78,770
25 YR Fixed 120,000 5.625 43.0 750 120,000
30 YR Fixed 3,895,346 5.996 65.6 715 169,363
3/1 ARM 13,672,420 4.379 72.2 706 506,386
5/1 ARM 98,924,604 5.095 73.1 716 349,557
7/1 ARM 33,797,026 5.291 69.3 738 462,973
- --------------------------------------------------------------------------------
Total 152,130,604 5.099 71.7 720 388,417
================================================================================
16
Effects of changes in Interest Rates
Changes in interest rates will impact our earnings in various ways. We are
currently invested primarily in hybrid ARM assets, which have a fixed rate
period ranging from 36 to 84 months. To the extent that these assets are
financed with shorter duration liabilities, rising short-term interest rates may
temporarily negatively affect our earnings, and, conversely, falling short-term
interest rates may temporarily increase our earnings. This may occur as our
borrowings react to changes in interest rates sooner than our hybrid ARM assets
because the weighted average next re-pricing dates of the borrowings may be
shorter time periods than that of the hybrid ARM assets.
Interest rate changes may also affect our net return, both positively and
negatively, given their impact on the level of prepayments experienced. In a
declining rate environment (all else being equal), prepayments on
mortgage-related assets tend to accelerate. This could potentially result in:
having to redeploy the additional funds at lower yield levels, weighting more
heavily the amount of our fixed rate financings, and accelerating any remaining
unamortized premiums paid.
Conversely, in a rising rate environment (all else being equal), prepayments
tend to decelerate. This could potentially result in: having fewer funds to
redeploy at higher yield levels, weighting more heavily the amount of our
floating rate financings, and extending any remaining unamortized premiums paid.
We attempt to mitigate any negative affects by managing our funding sources
(fixed vs. floating) and its use of the derivatives market (primarily interest
rate swaps).
Interest rate changes can also impact our investment opportunities. During a
rising interest rate environment, there may be less total loan origination and
refinance activity. At the same time, a rising interest rate environment may
result in a larger percentage of hybrid ARM products being originated,
mitigating the impact of lower overall loan origination and refinance activity.
Conversely, during a declining interest rate environment, consumers, in general,
may favor fixed rate mortgage products, but there may be above average loan
origination and refinancing volume in the industry such that even a small
percentage of hybrid ARM product volume may result in sufficient investment
opportunities.
Additionally, a flat yield curve may be an adverse environment for hybrid ARM
products because there may be little incentive for a consumer to choose an ARM
product over a 30 year fixed-rate mortgage loan and, conversely, in a steep
yield curve environment, ARM products may enjoy an above average advantage over
30 year fixed-rate mortgage loans, increasing our investment opportunities. The
availability and fluctuations in the volume of hybrid ARM loans being originated
can also affect their yield to us as an investment opportunity. During periods
of time when there is a shortage of ARM products, their yield as an investment
may decline due to market forces and conversely, when there is an above average
supply of ARM products, their yield to us as an investment may improve due to
the same market forces.
17
Subsequent Events
We entered into a contract with Blackrock Solutions ("Blackrock") to receive
risk management systems and analytical tools for the next three years. Blackrock
Solutions is the recognized leader in the risk management services and systems
business, especially with regard to financial institutions. Under the agreement,
Blackrock will provide services in a "risk management service bureau" capacity,
which includes daily risk position assessment and reporting. Blackrock will also
provide the use of their state of the art analytical system (with prepayment and
interest rate models) to enable us to quickly and accurately analyze investment
opportunities and hedging decisions. Management believes that the contract with
Blackrock Solutions will provide Sunset with the flexibility to effectively
pursue investment objectives and focus on our core business.
We have also entered into a forward commitment to purchase, at approximately
par, $85 million in seven year interest only hybrid ARM loans for June 21, 2004
settlement. These loans, which are subject to normal and customary caps, have an
average net loan rate of 4.61%, an average loan to value ratio of 70%, and an
average FICO score of 730.
As a part of our interest rate risk management, we have entered into a series of
interest rate swap agreements to increase the duration of our forecasted short
term borrowings program. Including the swaps entered into before the end of the
first quarter, the total notional amount of outstanding swaps as of April 30,
2004 was $183.8 million. The table below outlines the maturities and rates of
the swaps.
================================================================================
(in thousands) Notional Avg Fixed Rate
- --------------------------------------------------------------------------------
Maturing in less than one year --
Maturing between one and two years 63,000 1.79%
Maturing between two and five years 40,000 3.26%
Maturing in over five years 80,800 3.94%
================================================================================
In addition, we have closed and funded three additional commercial loans for a
total of $28.3 million bringing the total funded to $39.8 million. The loans
have a weighted average interest rate of 10.29% and have a weighted average term
of 10.79 months.
Other Matters
The Internal Revenue Code of 1986, as amended (the "Code"), requires that at
least 75% of our total assets must be Qualified REIT Assets, as defined by the
Code. The Code also requires that we meet a defined 75% source of income test
and a 90% source of income test. As of March 31, 2004, we calculated that we
were in compliance with all of these requirements. We also met all REIT
requirements regarding the ownership of our common stock and the distributions
of our net income. Therefore, as of March 31, 2004, we believe that we continue
to qualify as a REIT under the provisions of the Code.
18
We intend to conduct our business so as not to become regulated as an investment
company under the Investment Company Act of 1940, as amended. If we were to
become regulated as an investment company, our use of leverage would be
substantially reduced. The Investment Company Act exempts entities that are
"primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate" ("Qualifying
Interests"). Under current interpretation of the staff of the SEC, in order to
qualify for this exemption, we must maintain at least 55% of our assets directly
in Qualifying Interests as defined in the Code. In addition, unless certain
mortgage securities represent all the certificates issued with respect to an
underlying pool of mortgages, such mortgage securities may be treated as
securities separate from the underlying mortgage loans and, thus, may not be
considered Qualifying Interests for purposes of the 55% requirement. We
calculated that we are in compliance with this requirement.
19
Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information called for by Item 3 is incorporated by reference from the
information in Part I, Item 2 under the caption "Market Risks."
Item 4. CONTROLS AND PROCEDURES
Under the supervision, and with the participation of the Chief Executive Officer
and President, the Executive Vice President and Chief Investment Officer, the
Executive Vice President and Chief Marketing Officer and the Chief Financial
Officer and Treasurer, management has evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures as of the end
of the period covered by this quarterly report pursuant to Exchange Act Rule
13a-15e. Based on that evaluation, the Chief Executive Officer and President,
the Executive Vice President and Chief Investment Officer, the Executive Vice
President and Chief Marketing Officer and the Chief Financial Officer and
Treasurer, concluded that the Company's disclosure controls and procedures were
effective at March 31, 2004. There have been no significant changes in the
Company's internal controls that could significantly affect internal controls
subsequent to March 31, 2004.
20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of March 31, 2004 there were no pending legal proceedings to which we
were a party or of which any of our property was subject.
Item 2. Changes in Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits - see "Exhibit Index"
(b) Reports on Form 8-K
The Company filed the following Current Report on Form 8-K during
the quarter ended March 31, 2004:
(i) Current Report on Form 8-K filed on March 25, 2004 regarding
issuance of a press release announcing pricing of initial public
offering of common stock; filing underwriting agreement with W.R.
Hambrecht + Co., LLC, J.P. Morgan Securities Inc., and Stifel,
Nicolaus & Company, Incorporated; filing warrant to purchase common
stock; and filing incentive and non-qualified stock option
agreements.
21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Sunset Financial Resources, Inc
By: /s/ John Bert Watson
-----------------------------------
John Bert Watson
President and Chief Executive Officer
/s/ John Bert Watson May 7, 2004
- -----------------------
John Bert Watson
President and Chief Executive Officer
/s/ Michael L. Pannell May 7, 2004
- ----------------------
Michael L. Pannell
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)
22
Exhibit Index
Exhibit No
10.1 Contract with Blackrock Solutions
31.1 Certification of Chief Executive Officer pursuant to Securities Act
Rules 13A-14 and 15D-15
31.2 Certification of Chief Financial Officer pursuant to Securities Act
Rules 13A-14 and 15D-15
32.1 Certification of pursuant to 18 U.S.C Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of pursuant to 18 U.S.C Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
23