In the face of a considerably more adverse business environment for mortgage Real Estate Investment Trusts ("mREITs"), American Capital Agency Corp. (AGNC) has so far made one relatively small adjustment to its dividend:
Figure 1: AGNC dividends
The most recent dividend announcement occurred on December 14, 2012, and the amount was held steady at $1.25 per quarter (payable 1/28/13).
AGNC currently yields ~16.1%. However, investors familiar with my approach know the first question I ask is what portion, if any, of the dividends I am receiving are really "earned". I am leery of investing in entities (publicly traded partnerships or companies) that pay dividends, or fund distributions, by issuing debt or additional equity.
In taking a closer look at AGNC I encountered difficulties similar to those I faced when reviewing the performance of MLPs. Since money is fungible and AGNC's annual report runs to almost 100 pages that are frequently hard to understand, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.
Several examples can illustrate the complexities. The bulk of AGNC's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or Ginnie Mae, and of corporate debt (together, "Agency Securities"). These are classified for accounting purposes as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. Another example is discontinuing hedge accounting for its interest rate swaps beginning in 4Q 2011. This reduces the balance of net losses accumulated on the balance sheet (under "Accumulated Other Comprehensive Income") with respect to such interest rate swaps and increases the interest expenses over the remaining contractual terms of these swaps.
The treatment of cash receipts and payments related to derivative instruments is yet another example. They are classified according to the underlying nature or purpose of the derivative transaction, and therefore appear in the operating section of the cash flow statement if the derivatives are designated as hedges. But they appear in the investing section of the cash flow statement if they are not designated as hedges. Therefore, I find AGNC's distinctions between the various categories on the cash flow statement (i.e., operations, investments and financing) to be of limited value in understanding AGNC's ability to generate sustainable dividends.
In light of these issues, I created a simplified cash flow statement designed to shed light on the sustainability of the dividends by, for example, grouping together and netting out numerous line items that deal with gains and losses that are reported in the income statement but are non-cash items (and therefore reversed out in the cash flow statement). I also separate cash generation from cash consumption and group together and net out numerous line items that deal with cash outflows for assets (e.g., acquiring assets outright or receiving assets as collateral and lending against them) and cash generated by assets (e.g., selling assets outright or giving assets as collateral and borrowing against them). This reduces AGNC's cash flow statement to just a few lines and provides an initial indication of whether distributions are funded by asset sales and or equity/debt offerings. Results for the quarters ending 9/30/12 and 9/30/11, and for the trailing twelve-months ("TTM") ending on those dates, are outlined in Table 1 below:
Simplified Cash Flow Statement:
Table 1: Figures in $ Millions
In these simplified cash flow statements proceeds from, and payments for, assets contain numerous types of netted items, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; d) principal payments on, or maturities of, securities owned; e) equity investments (including investments in affiliates). Of course, the net increase (decrease) in cash and cash equivalents ties to the company's financial statements.
Asset sales and equity/debt offerings are clearly not sustainable sources of cash and, according to Table 1, were not used to fund AGNC's distributions. But what portion of the other Table 1 items grouped under "Cash from potentially sustainable sources" is indeed sustainable Distributable Cash Flow ("DCF")?
My preference is to use net interest income as a proxy for AGNC's sustainable DCF. One way to do this analysis is presented in Table 2 below:
The shortfall for 3Q12 indicated in Table 2 amounts to ~13% of the amounts distributed. Since 4Q12 dividend was maintained at $1.25 per share, it seems that management has not yet aligned its dividends to AGNC's sustainable DCF.
Another way to estimate sustainable DCF based on net interest income, presented in Table 3, indicates sustainable DCF of approximately $1.06 per quarter or ~15% less than the current quarterly distribution.
Table 3: Sustainable dividend yield; figures in $ Millions
Based on Tables 2 and 3, my assessment is that sustainable DCF is ~14% below, the current distribution rate assuming, of course, no further deterioration in net interest margin. My assessment is that management will need to align its dividend distribution to a level that more closely approximates sustainability. The question is whether this is already priced into the stock.
In its discussion of results for 3Q12, management cited a 59% annualized economic return on common shares, comprised of $1.25 dividend per common share and $3.08 increase in net book value per common share. But it is no great feat to increase book value when additional shares are issued at a price that is in excess of book value. Indeed, a significant portion (~57%) of the increase in book value was generated by issuing 36.8 million shares at $33.70 in July 2012 (the book value was $29.41). The balance of the increase in book value in 3Q12 was also generated by what I consdier to be non-sustainable sources (net unrealized gains on investments marked-to-market through Other Comprehensive Income).
In its discussion of 3Q12 results, management also mentioned it has received authorization to acquire up to $500 million of common shares through December 31, 2013, but stated it would do so "only when it is meaningfully accretive to our net book value per common share". Net book value was $32.49 as of 9/30/12 and I doubt the current stock price level ($31.15 as of 12/21/12) is low enough to create meaningful accretion. My guess is that management will keep its powder dry and will purchase shares only at much lower levels.
I am long Annaly Capital Management, Inc. (NLY) but do not have a position in AGNC. It is quite possible AGNC would have been a better choice (my comparative analysis is not yet complete), but in any event despite the drop in price and still high dividend yield I do not intend to significantly increase my exposure to mREITS. The current market environment (narrowing net interest margins and high prepayment rates) remains very difficult for mREITS such as AGNC. I do not see this changing in the near future, although management's claim that it has positioned its investment portfolio towards agency MBS that it believes have favorable prepayment attributes gives rise to some optimism.
Disclosure: I am long NLY.