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Despite the fact that the last quarter of 2012 was heavily influenced by Fed's purchases of agency mortgage-backed securities, American Capital Agency Corp. (NASDAQ:AGNC) was able to post strong results. AGNC reported 32% economic ROE for the full year and a core EPS of $2.37 for Q4 2012, which was almost 10 times higher than the core EPS reported in Q3 2012.

Summary

Click to enlarge images.

Source: Company reports.

Financial Highlights

1. Net Income

AGNC was able to grow its core net income at a phenomenal pace in Q4 2012 despite the Fed's QE3 and buying of agency-mortgage backed securities. AGNC reported a core net income of $807 million in Q4 2012, which on a year-over-year basis is almost four times the core net income reported in Q4 2011.

2. EPS

AGNC was able to post an EPS of $2.37 in Q4 2012, which was almost two times the EPS posted in Q4 2011 of $0.99. Despite the Fed's asset purchase program, AGNC was able to manage its asset portfolio well. Also, 77% of the company's fixed rate assets were made up of securities backed by lower loan balance mortgages and loans originated under the HARP program. These securities have favorable prepayment attributes and, therefore, a lower risk of prepayment relative to generic agency securities. This has been one of the major factor that has contributed to improving earnings.

Source: Company reports.

3. Dividends

As announced, AGNC paid a solid dividend of $1.25 per share in Q4 2012. The dividends in absolute dollar terms have remained stable over the last many quarters. However, dividend payout ratio has fluctuated quite dramatically. See chart below:

Source: Company reports.

4. ROE

ROE reported for Q4 2012 was 28.75%, which is almost 25% higher than the ROE reported in Q3 2012 and almost two times the ROE reported in Q4 2011. This exceptional performance can be attributed to sound and active management policies and asset allocation across a broad spectrum of agency mortgage-backed securities. This was the fourth consecutive year in which AGNC was able to generate a return exceeding 30% for its shareholders.

Source: Company reports.

5. Constant Prepayment Rate

AGNC reported CPR of 10%, which is 1% lower than the CPR reported for Q3 2012 and Q4 2011. AGNC has one of the lowest CPRs within the agency mortgage REITs. Comparing AGNC with NLY, Q4 2012 CPR for AGNC is 9% lower than the Q4 2012 CPR reported by NLY, which stands at 19%. Lower CPR speaks of management's ability to manage risk. Lower prepayments are an indication of stable earnings going forward.

6. Net Interest Spread

Net interest spread rose by 21bps from 1.42% in Q3 2012 to 1.63% in Q4 2012. Although spread has improved recently, it is much lower as compared to where it was at the start of 2012. Spread is down almost 68 bps from Q1 2012. As can be seen in the chart below, cost of funds were pretty much unchanged over the last few quarters. Spread has changed primarily because of variation in yield on earning assets.

Source: Company reports.

7. Valuation

As of Dec. 31, 2012, book value per share of AGNC was $31.64. That is slightly lower than the book value reported in Q3 2012, but almost 12% higher than the book value reported in Q4 2011. The current trading price for AGNC is $31.77, which means it is trading at a premium of 40 bps from book value as of Dec. 31, 2012.

Source: Company reports.

Conclusion

Improving ROE, declining prepayment rates, and increasing net interest spread will stabilize earnings going forward. On a valuation basis, AGNC is priced perfectly at the moment. However, in terms of future potential, AGNC seems unmatchable. In my view, another factor that will play an important part in the future will be the purchase of Agency MBS on a forward settlement basis via the TBA dollar roll market. The company's earnings release states:

Since commencing QE3, the Federal Reserve's purchases of agency MBS have had the effect of lowering net interest rate spreads on lower coupon agency MBS. However, the Federal Reserve's involvement in the mortgage market has also made it more attractive to purchase agency MBS on a forward-settlement basis through the TBA dollar roll market.

Since I am of the view that QE3 will remain in place during 2013, the size of the purchases may vary. Therefore, AGNC will be in a good position to benefit from purchase of Agency MBS on a forward settlement basis. Based on my analysis, I believe that AGNC will be able to grow its book value consistently in the future as well. Therefore, I would recommend buying AGNC.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Dividend Pros covering U.S financials.

Source: American Capital Agency - A Snapshot Of Q4 2012 Results