Although American Capital Mortgage (MTGE) will not achieve the same level of performance in Q4 2012 and FY 2013, this isn't due to anything that could be laid at the feet of the company's management. We believe that American Capital Mortgage's CEO Malon Wilkus has created one of the finest income-oriented investment vehicles with his American Capital Ltd (ACAS) company as well as its two most well-known mortgage real estate investment trust vehicles American Capital Agency (AGNC) and American Capital Mortgage. American Capital Agency was founded in 2008 and it hired Gary Kain from Freddie Mac to serve as its dedicated Chief Investment Officer. Due to the successful performance of American Capital Agency in the dedicated agency-backed MBS segment from 2008 to 2011, American Capital decided to set up a hybrid mREIT that would be allowed to invest in non-agency backed MBS Securities. The team of Wilkus and Kain took MTGE from a 2011 start-up to $7.55B in assets as of Q3 2012. We most certainly do not expect it to generate the 55.5% cumulative return over the next 15 months that it achieved in its first 15 months. At the same time, we expect it to continue to outperform Annaly Capital Management (NLY), which has earned its reputation as the lumbering behemoth of the mREIT industry.
Source: Morningstar Direct
The first item that drives our MTGE over Annaly thesis is based on the financial reporting of each company. MTGE has the same reporting dynamic as its mREIT big brother AGNC since both firms are sponsored by American Capital. We found AGNC's reporting to be superior to Annaly's in terms of understanding what is going on and to evaluate the financial and operating performance of each firm and it is no surprise that MTGE's financial reporting is also easier to understand and easier to utilize versus Annaly. MTGE offers a separate calculation schedule to compute its core net interest spread income whereas the only mention of Annaly's core net interest spread income is buried in its earnings press release. Another example of MTGE's superior financial reporting is how it reports its CPR Prepayment Rates and other Key Performance Statistics. We find that MTGE's Key Performance Statistics Reporting in its earnings releases is more robust than Annaly's plus it offers greater organization of the key operating metrics. MTGE has its CPR Prepayment Rates in with its Key Performance Statistics in its quarterly earnings releases while Annaly has its CPR in a paragraph after its Key Performance Statistics Table.
Although MTGE's asset base is about one-twentieth of Annaly's, both companies report financial statement performance in thousands of dollars. We previously remarked about how AGNC reports its financial statements in millions of dollars, rather than the thousands of dollars that Annaly uses. We're surprised that Annaly reports its financial statement results in thousands of dollars rather than millions of dollars considering that Annaly is almost 39% bigger than AGNC in terms of balance sheets assets and 20X as big as MTGE.
American Capital Mortgage's dividend yield of 15.5% is 200bp higher than Annaly's 13.5%. We don't expect any per share dividend growth from either mREIT and we expect both companies to potentially cut dividends by 20-30% over the next year. American Capital Mortgage hasn't had to cut its dividend yet while Annaly has cut its dividend six times in the last three years, including four times in the last five quarters. Annaly's per share dividends have declined by 33% in this time period.
The most important factors behind our American Capital Mortgage over Annaly thesis is that MTGE has better operating performance metrics than Annaly. Annaly has done a good job in positioning itself as the senior statesman, conservative risk-management oriented mREIT. The good news for Annaly is that even after its acquisition of CreXus (CXS), we believe that the company will maintain this image as long as it doesn't acquire Chimera (CIM). The bad news is that Annaly's performance pales in comparison to American Capital Mortgage's performance. We previously analyzed how MTGE's big brother American Capital Agency is still performing better than Annaly with regards to key operating metrics even though it surpassed the $50B asset level last year and the $100B asset level this year, Annaly's stakeholders can't really make the case that Annaly's weak performance is due to its massive size because AGNC is not that much smaller than Annaly anymore. American Capital Mortgage has also generated superior financial operations performance than Annaly and this is why MTGE has enjoyed rapid growth in its asset base since its August 2011 inception.
Source: Morningstar Direct
The first performance metric that validates our thesis is the cost of funds. Annaly's cost of funds in the most recent quarter was 1.52% versus AGNC's 0.96%. We were surprised that Annaly would have such a high cost of funds considering it has its own broker-dealer operations and it tries to show how conservative it is. Regardless of whether Annaly's record is matching its rhetoric, we would think that Annaly would be the one with the lower cost of funds. Annaly's cost of funds does not include its non-interest expenses despite what its apologists have said. Despite the fact that AGNC has a lower cost of funds than Annaly, its average asset yield as of the period end was only 3bp lower than Annaly's. That surprised us because we would expect MTGE to have the higher average gross yield and Annaly to have the lower cost of funds.
One area that we are not surprised that MTGE beats Annaly in is its CPR prepayment rate. Considering that Annaly's CPR prepayment rate has been 16% or higher since 2009 with the exception of an 11% CPR in Q2 2011, we're speculating that Annaly is going out of its way to chase prepayment. That probably explains why although Annaly's performance since 2009 has been in line with the average mREIT, it has been a severe laggard relative to Gary Kain's mREITs. MTGE's CPR prepayment rate has not only outclassed Annaly's CPR prepayment rate, it has also done a better job managing prepayments than its big brother AGNC.
In conclusion, we still see MTGE as one of our favorite mREITs especially because it is repurchasing $50M of its stock. We think that the only part of Annaly's conservative, risk-management-oriented thesis that holds is that it uses less leverage than MTGE and other higher quality mREITs. Other than that, we can see that MTGE offers investors greater investment potential than Annaly on a nominal and risk adjusted basis. Annaly may be the mREIT industry's bellwether but we see the performance of American Capital's mREITs MTGE and AGNC ringing Annaly's bell. The last reason why we believe that MTGE is a better mREIT for investors than Annaly is because while Annaly's management is great at making glib commentary about macroeconomic events, we find that American Capital's Gary Kain is better at managing the macroeconomic environment than the late Mike Farrell and his successor Wellington Denahan-Norris at Annaly.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the article’s recommendation. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.