CYS Investments, Inc (CYS) has had a rough time since it announced its third quarter earnings on October 17, 2012. The stock has drifted down over 10% to its current price of $11.67 as of November 14, 2012. The stock has a current dividend yield is over 15%. The current stock price is also a 20% discount to the net asset value $14.46. I believe the market is undervaluing this and it is due to rebound.
Here is an overview of the company from its investor relations page:
CYS Investments, Inc. is a specialty finance company that was created with the objective of achieving consistent risk-adjusted investment income. They achieve this objective by investing on a leveraged basis in residential mortgage pass-through securities for which the principal and interest payments are guaranteed by the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or Freddie Mac, or the Government National Mortgage Association, or Ginnie Mae, and collateralized by single-family residential mortgage loans. CYS Investments, Inc. has elected to be taxed as a real estate investment trust for federal income tax purposes.
Below is an overview of the Q3 results:
CYS reported GAAP net income of $241.9 million during the third quarter of 2012, or $1.46 per share, compared to net income of $101.7 million, or $0.87 per diluted share, in the second quarter of 2012. During the third quarter of 2012, CYS had Core Earnings of $41.2 million, or $0.25 per share, compared to $44.8 million, or $0.38 per share, in the second quarter of 2012.
CYS defines core earnings as the following:
Core Earnings represents a non-GAAP financial measure and is defined as net income (loss) available to common shares excluding net realized gain (loss) on investments and termination of swap contracts and net unrealized appreciation (depreciation) on investments and swap and cap contracts.
CYS defines drop income as the following:
Drop income is a component of net income accounted for as net gain from investments on our statement of operations and therefore excluded from our Core Earnings. During the third quarter of 2012, the Company generated drop income of approximately $36.9 million, or $0.23 per diluted share, compared to approximately $15.0 million, or $0.13 per diluted share, during the second quarter of 2012.
Core Earnings plus drop income was $0.48 per share during the third quarter of 2012 compared to $0.51 during the second quarter of 2012. This is a$0.03 quarter-over-quarter decrease in Core Earnings plus drop income per diluted share.
CYS recorded $745.3 million in scheduled and unscheduled principal repayments and prepayments, which equated to a constant prepayment rate ("CPR") of approximately 17.3% and net amortization of premium of $29.5 million for the third quarter of 2012. This compared to $651.7 million in scheduled and unscheduled principal repayments and prepayments, which equated to a CPR of approximately 18.1% and net amortization of premium of $22.7 million for the second quarter of 2012.
CYS noted that the decrease in CPR during the third quarter of 2012 was consistent with seasonal trends. However, the CYS expects the fourth quarter 2012 CPR will increase due in part to the Federal Reserve Board's (the "Federal Reserve") announcement of an open-ended program to purchase an additional $40 billion of Agency RMBS per month until the unemployment rate, among other economic indicators, show signs of improvement. This program, when combined with the Federal Reserve's existing programs to extend its holdings' average maturity, and reinvest principal payments from its holdings of agency debt and Agency RMBS into Agency RMBS, is expected to increase the Federal Reserve's holdings of long-term securities by approximately $85 billion per month through the end of 2012.
CYS's operating expenses were $5.3 million, or 0.93% of average net assets, for the third quarter of 2012, compared to $5.3 million, or 1.33% of average net assets, for the second quarter of 2012. Operating expenses as a percentage of net assets decreased as a result of a larger asset base.
CYS noted that it utilizes interest rate swap and cap contracts to hedge the interest rate risk associated with its Agency RMBS portfolio. As of September 30, 2012, CYS had entered into 20 interest rate swap contracts with an aggregate notional amount of $7.0 billion, a weighted average fixed rate of 1.298%, and a weighted average expiration of 2.7 years. At September 30, 2012, CYS had entered into ten interest rate cap contracts with a notional amount of $3.4 billion, a weighted average cap rate of 1.622%, and a weighted average expiration of 6.8 years.
NET ASSET VALUE
CYS's net asset value per common share on September 30, 2012 was $14.46, after declaring a $0.45 dividend per common share on September 11, 2012, compared with $13.52 at June 30, 2012. The increase was primarily the result of Agency RMBS outperforming swaps.
CYS currently trading for $11.67. This leads to a discount to net asset value of 20%.
YIELD ON AGENCY RMBS
The average yield on Agency RMBS for the third quarter of 2012 was 2.25% , compared to 2.62% in the second quarter of 2012.
COST OF FUNDS
The average cost of funds and hedge for the third quarter of 2012 was 1.01% , compared to 0.91% in the second quarter of 2012.
INTEREST RATE SPREAD
CYS's interest rate spread net of hedge decreased to 1.24% for the third quarter of 2012 from 1.71% in the second quarter of 2012.
CYS's leverage ratio at September 30, 2012 was 7.7. This is an increase from the 7.6 in the second quarter of 2012.
CYS declared a common dividend of $0.45 per share with respect to the third quarter of 2012, compared to $0.50 for the second quarter of 2012.
DIVIDEND TO CASH FLOW
When considering CYS dividend payout ratio it is best to use drop income plus core earnings instead of net income. This removes the effect of unrealized appreciation and or depreciation on investments and swap and cap contracts.
Using the Core Earnings plus drop income of $0.48 from above and the declared dividend of $0.45 we get to a payout ratio of 94%. Historically this ratio has been a good predictor, as Core Earnings plus drop income has declined, so has the dividend.
CYS has had decreasing core earnings and interest rate spreads. These factors may lead to a dividend cut next quarter. However, CYS has used drop income to help mitigate this decline in the past. CYS has also steadily increased its Net Asset Value. Net Asset Value has increased 7% since the second quarter of 2012 and nearly 25% since the fourth quarter of 2010.
CYS currently trades for $11.67. The yield is 15.4% if CYS were to maintain its $0.45 per quarter dividend. The stock also trades at a massive 20% discount to its Net Asset Value of $14.46. This stock is a bargain at these levels.
Disclosure: I am long CYS.