Seeking Alpha
Research analyst, REITs, biotech, small-cap
Profile| Send Message|
( followers)  

Oh what a year 2013 has been, but the worst is probably over for the mortgage real estate investment trusts (mREITs). At least, that is my opinion after covering these stocks for some time. My two favorite mREITs are the behemoths in the space, Annaly Capital Management (NYSE:NLY) and American Capital (NASDAQ:AGNC) at present share levels. This is especially true given the most recent Q2 report from NLY and the most recent AGNC Q2 report. Things seem to be improving. When considering their performance which I will discuss a bit here, we have to ask ourselves which stock is better going forward? Those who follow my work know that I have built a position on the way down as they have absolutely plummeted in 2013. Much of the selloff was in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year. Second was the fear that rising interest rates will crush portfolio holdings of the mREITs. Third, the last few quarters were worrisome. In this article, I will discuss and compare the most recent quarter of each company and lay out why I believe shares are undervalued and heading higher. Further I will suggest which of the two stocks I think represents a better value between AGNC and NLY. While I frequently opine on both stocks, I have been asked by several readers my overall opinion of which is better. Therefore, I'd like to go over the key takeaways from the most recent quarter that investors should focus on when deciding for themselves which is the better buy, but ultimately recommend one over the other.

NLY Earnings

Overall, it looked pretty good. NLY reported a GAAP net income for the quarter of $1.6 billion or $1.71 per average common share as compared to GAAP net income of $870.3 million or $0.90 per average common share for the first quarter 2013. These numbers are even better compared to the comparable 2012 quarter, which was reported to be a net loss of $91 million or $0.10 a share.

AGNC Earnings

Overall, it looked pretty ugly at first. AGNC reported a nasty $2.37 comprehensive loss per common share, comprised of $4.61 in net income per common share and a $6.98 other comprehensive loss per common share. This equates to an overall loss of $936 million for the quarter.

In my opinion, it's pretty obvious NLY's headlines earnings were better. But what about other key metrics?

NLY's Spread on Interest Rates

With interest rates moving wildly during the quarter ended June, I had expected the interest rate spread for mREITs to actually improve as I predicted that the cost of borrowing would rise at a slower pace than the rise in yield being returned from investments. For the case of NLY, this proved to be true. The interest rate spread saw a slight increase quarter over quarter. To my pleasant surprise, NLY reported a net interest rate spread of 0.98%, which was a slight but meaningful change from the first quarter, which was reported to be 0.91%. This was a great sign for those who believe that the company may be stabilizing, but unfortunately, is still well below the 1.54% interest rate spread from the comparable quarter last year.

Let's look at this a bit more to see where the asset yields and costs of funds stand. First, NLY's asset yield on its interest earning portfolio for the quarter was 2.51%, compared to 2.37% for the first quarter. Not surprisingly, this is much lower than the yield in the comparable quarter of 2012. Although it is still diminished from 2012 levels, it was a marked improvement from Q1 2013 of 6%. Furthermore, NLY's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 7 basis points to 1.53% for the second quarter, up from 1.46% for the first quarter, primarily due to higher average costs associated with entering into longer dated swaps during the quarter.

AGNC's Spread on Interest Rates

The interest rate spread was essentially stagnant. To my surprise, AGNC reported a net interest rate spread of 1.86%. Basically, it didn't change from the first quarter at all, which was reported 1.87%. If we exclude TBA dollar roll income, then AGNC's net spread was 1.49% -- essentially the same as Q1, which was reported as 1.51%. Furthermore, AGNC's asset yield on its agency security portfolio for the quarter was 2.92%, compared to 2.80% for the first quarter. The annualized weighted average yield on the agency security portfolio was 2.63% for the current quarter, compared to 2.64% for the prior quarter, backing out the amortization catch-up payments. Overall, AGNC's average asset yield reported as of June 30, 2013, was 2.71%, a four-basis-point decrease from 2.75% as of March 31, 2013. Furthermore, AGNC's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 15 basis points to 1.43% for the second quarter, from 1.28% for the first quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter. As a result, the average cost of funds as of June 30, 2013, increased 15 basis points to 1.47% from 1.32% as of March 31, 2013.

To put this all into perspective, the cost to borrow rose but the average yield on assets rose at higher absolute amount, leading to a higher interest rate spread quarter over quarter for NLY. Thus, earnings potential as a result of the interest rate spread has started to rebound For AGNC, we saw a stagnant spread, but the cost of funds and yields both rose. This statistic is one of the first things I examine when looking at the performance of any mREIT. Overall, it wasn't that bad for either company. AGNC is a winner hands down for a larger spread, but NLY takes the cake for the category in my opinion because it showed improvement quarter over quarter. The street likes improvement/growth, versus stability, at least for capital appreciation chances.

NLY's Dividend?

The dividend of $0.40 per share was down 11% from the last dividend of $0.45 per share declared in the first quarter. It is also 27% lower than the Q2 2012 dividend of $0.55. It should be noted that this number was actually better than expected, as it was widely believed that the dividend was going to be cut to $0.35 or even as low as $0.25. The dividend was well within NLY's estimated taxable income per share of $0.47. Therefore, NLY did have sufficient cash and earnings to pay it. At a current share price of $11.30, this represents a still sizable yield that NLY has been known for, currently an annualized yield of 14.0%.

AGNC's Dividend?

The dividend of $1.05 per share was down 16% from the last dividend of $1.25 per share. It should be noted that this number was actually better than expected as it was widely believed that the dividend was going to be cut to a dollar or less. Some were opining it could drop as low as $0.80. At first glance it would appear that the dividend was greater than AGNC's estimated taxable income per share of $1.04. However the $1.05 payment per share is in reality less than AGNC's net spread and dollar roll income. That figure came in at approximately $1.15 per share. While the dividend paid was definitely up against this number, AGNC did have sufficient cash to pay it. At a current share price of $21.90, this represents a still sizable yield that AGNC has been known for of 18.9%.

It is important to note that this dividend can certainly fluctuate moving forward, but now that interest rates movements have calmed down, it is likely that we can expect this dividend to stay at current levels for the time being for both stocks. NLY's dividend decrease was relative lower than AGNC's, as NLY's declined 11% while AGNC's declined 16%. While AGNC is still paying a far better yield, the deterioration in the dividend is outpacing that of NLY's. While AGNC is the winner for higher dividend, for future prospects right now NLY takes the cake given it has a lower rate of dividend reduction.

NLY's Book Value

Book value dropped but as of June 30th the stock was indeed trading below tangible book value. On June 30th, the stock was trading around $12.50. The book value was reported to be $13.03, which was a $2.16 drop from the end of Q1. However, it also meant that the stock was trading about 5% below book value, indicating at the time it was probably a decent buy at the time.

AGNC's Book Value

As of June 30 the stock was indeed trading well below tangible book value. On June 30, the stock was trading around $23.00. The book value was reported to be $25.51, which was a $3.28 drop from the end of Q1. However, it also meant that the stock was trading about 12% below book value, indicating at the time it was a great buy.

Much of the decline in both names was due to the volatility in mortgage-backed securities (MBS), and as such many investors and traders were just dumping the stock for fear that it could have been much worse. Considering the stabilization in MBS prices and interest rates over the last few weeks, we can likely safely conclude that book value has stabilized as well in both names. To declare a winner here I think it is best to look at relative decline in book value. NLY lost $2.16 from $15.19 to $13.03 for a 14.2% decline. AGNC on the other hand, lost $3.28 from $28.79 to $25.51 for an 11.4% decline. In this case, hands down AGNC was the better performing, losing far less book value in absolute percentage values.

Choosing the better value

The quarter was a significant improvement over the first quarter 2013 for both companies. The earnings were pretty good for NLY and not so great for AGNC. But don't let earnings alone dictate the decision. Investors should focus on two of the most important items to consider with the mREITs. First is the interest rate spread. It rose nearly 10% quarter over quarter for NLY, but was stagnant for AGNC. This is a crucial positive for both companies as it suggests both are stabilizing. Right now it appears the worst is over for both stocks on the spread, but NLY is widening its spread. AGNC, however, has a larger spread. In my opinion, the Street tends to reward expanding metrics, not stagnant ones. Another important metric is book value. This measure should properly determine the share price of your mREIT and be used as a basis for deciding whether to buy or sell. Book value for both companies was above the stock price at the end of the quarter. However, it declined more significantly for NLY during this time. Finally, there is the dividend. AGNC pays a higher yield, but the dividend itself is deteriorating faster than NLY's. While I like both companies, and hold a substantial position in both (my AGNC position is 18% larger in value than my NLY position), right now I believe that NLY is the better buy of the two stocks based on these fundamental mREIT metrics.

Source: Buy Annaly Over American Capital Agency?