In a prior article I outlined a methodology for assessing the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC), a Nasdaq-listed mortgage real estate investment trust with a market capitalization of ~$8.7 billion and assets on the balance sheet as of 6/30/13 totaling ~$98 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. This article applies the methodology to evaluate AGNC's results of operations and dividend sustainability as of 2Q13.
The bulk of AGNC's assets consist of mortgage-backed securities and debentures issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) 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 ~19.4%. 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. The first significant difficulty faced by an investor trying to answer this question is encountered when attempting to analyze key business parameters within AGNC's income statement, as outlined in Table 1 below. Given the significant quarterly fluctuations, Table 1 includes trailing 12 months ("TTM") figures in addition to the quarterly numbers.
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 second significant difficulty faced by an investor trying to ascertain whether the dividend yield is sustainable is a cash flow statement exceedingly complex and difficult to decipher. For example, 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.
The simplified cash flow statement in Table 4 below is designed to shed light on the sustainability of the dividends by grouping together and aggregating 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 ~30 line items in AGNC's cash flow statement and provides an initial estimate of cash generated by potentially sustainable sources.
Simplified Cash Flow Statement:
Table 2: Figures in $ Millions
There have been no further dividend reductions beyond the move from $1.40 to $1.25 per share per quarter in 1Q12. Yet Table 2 shows the absolute dollar amount of dividends paid in 2Q13 and the TTM ending 6/30/13 increased substantially over the prior year periods. This is because of the dramatic increase in the number of common shares outstanding increased (e.g., by ~53% in the latest TTM period).
I do not consider items below the Subtotal line as 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:
Table 3: Figures in $ Millions, except DCF coverage
However, conclusions based on the Table 3 analysis may not provide an accurate enough picture because the GAAP measurement net interest income does not include all the expenses of interest rate swaps. For example, AGNC engages in a form of off-balance sheet financing of agency MBS on a generic pool, or to-be-announced ("TBA"), basis. In TBA dollar roll transactions AGNC purchases agency MBS paper for a forward settlement date. The difference between the price paid and the price of the same paper for settlement in the current month is referred to as the "price drop". The price drop is the economic equivalent of the net interest carry (interest income less implied financing cost). The amounts are significant (~$29 billion on a cost basis during 2Q13) and AGNC accounts for these positions as derivative instruments and recognizes dollar roll income in other income (loss) on the Company's financial statements.
In light of this, I look for a model that can provide a better view as to what is happening to 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]. This model is presented in Table 4 below:
Several observations: First, net interest rate spreads are shrinking. Second, the decrease in leverage reflects only on-balance sheet debt (i.e., TBA contracts are off-balance sheet). Inclusive of the net TBA position, leverage was 8.4 times stockholders' equity as of June 30, 2013. Making that adjustment to the Table 4 model would increase the sustainable quarterly dividend to $1.05.
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, it seems that management has not aligned its dividends to what AGNC can sustain. The harder question to answer is how large a dividend reduction is already incorporated into the stock price. Still, investors for whom a sustainable dividend stream is important should beware.