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American Capital Agency Corp. (NASDAQ:AGNC) is a Nasdaq-listed mortgage real estate investment trust with a market capitalization of ~$11 billion and assets on the balance sheet as of 3/30/13 totaling ~$93 billion. AGNC owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations, callable debentures and other securities backed by pools of mortgage loans.

The bulk of AGNC's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or Ginnie Mae (together, "Agency Securities"). AGNC relies primarily on short-term borrowings to acquire Agency Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.

AGNC currently yields ~18.2%. 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 fund dividends or distributions using non-sustainable sources. In taking a closer look at AGNC I encounter significant difficulties. Excerpts from the income statements for the quarters ending 3/31/13 and 3/31/12, and for the trailing twelve-months ("TTM") ending on those dates, illustrate some of these difficulties:

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Table 1: Figures in $ Millions

AGNC's Agency Securities 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. The effect can be dramatic, as seen in Table 1. The unrealized gains and losses on Agency Securities show up only on the balance sheet, not the income statement. Unrealized gains (losses) on interest rate swaps and other derivative instruments are treated similarly. Therefore, I find AGNC's reported earnings, earnings per share and earnings multiples to be of limited value as indicators of performance or of ability fund dividends from sustainable Distributable Cash Flow ("DCF").

The cash flow statement presents another illustration of the difficulties encountered in trying to ascertain whether you are genuinely receiving a yield on your money (rather than a return of your money). AGNC classifies cash receipts and payments related to derivative instruments according to the underlying nature or purpose of the derivative transaction. Therefore, if the derivatives are designated as hedges they appear in the operating section of the cash flow statement. But if they are not designated as hedges, they appear in the investing section of the cash flow statement.

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, as a first step, I developed a simplified cash flow statement designed to shed light on the sustainability of the dividends. This simplified statement groups together and aggregates numerous non-cash line items that deal with losses (gains) on assets & liabilities reported in the income statement. It also aggregates proceeds from, and payments for, numerous types of assets and liabilities, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; and d) principal payments on, or maturities of, securities owned. This eliminates a considerable portion of the ~40 line items in AGNC's cash flow statement and provides an initial estimate of cash generated by potentially sustainable sources.

Simplified Cash Flow Statement:

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Table 2: Figures in $ Millions

Of course, the net increase (decrease) in cash in Table 2 ties to the number in the company's financial statements.

Items such as common shares issued are clearly not sustainable sources of cash. The question is what portion of the items grouped under "Cash from potentially sustainable sources" in Table 2 is indeed sustainable? The second step of my analysis derives that portion by looking at net interest income and then deducting expenses as a proxy for AGNC's sustainable DCF, as presented in Table 3 below:

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Table 3: Figures in $ Millions, except DCF coverage

There have been no further dividend reductions beyond the move from $1.40 to $1.25 per share per quarter in 1Q12. Despite this reduction, total dividend payments increased substantially in the TTM ending 3/31/13 over the prior year period because the number of common shares outstanding increased by ~74% It seems to me that management has not aligned its dividends to what AGNC can sustain.

Table 3 indicates the dividends have been partially financed by sources I deem unsustainable. However, it does not give a good enough view of AGNC's sustainable earnings power or what is happening to its basic business model. The next step in the analysis is presented in Table 4 below:

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Table 4

AGNC's bread and butter business of using short-term borrowings to acquire mortgage-backed securities and debentures issued by U.S. government agencies (Fannie Mae, Freddie Mac or Ginnie Mae) is modeled in Table 4. The basic problems facing AGNC in executing the model are highlighted in this model.

First, net interest rate spreads are shrinking. Second, on-balance sheet leverage appears to have decreased (see comments below). Third and having lesser impact, book value per share has declined.

The decrease in leverage is exaggerated because the numbers in the financial statements do not include contracts for the purchase or sale of agency MBS securities on a generic pool, or to-be-announced, basis ("TBA contracts") and on a non-generic specified pool basis TBA and forward settling agency securities positions. AGNC significantly increased its TBA positions while reducing on-balance sheet agency MBS investments financed through repurchase agreements. Effectively, AGNC's "at risk" leverage has increased, not decreased. Inclusive of the net TBA position, leverage was 8.1 times stockholders' equity as of March 31, 2013. But even if you adjust by increasing leverage in the Table 4 model to 8.1, the sustainable quarterly dividend calculates at $0.98 per quarter based on the 3 months ended 3/31/13.

The emphasis on off balance sheet financing via TBA contracts did not seem to work in AGNC's favor in 1Q13. But management expects the adverse effect to be reversed in 2Q13.

A continuing narrowing of net interest margins makes the current environment very difficult for mortgage REITs such as AGNC. I do not see this changing in the near future. Based on my analysis, the current $1.25 per quarter dividend yield is not sustainable. An argument can be made that a reduction may already be incorporated into the stock price so that a drop to $1.00 per share per quarter (or even less) may not cause a substantial decline in the share price.

Source: Methodology For Assessing Sustainability Of American Capital Agency's 18.2% Dividend Yield