Has Armour Residential Become A Value Trap?

| About: ARMOUR Residential (ARR)

ARMOUR Residential REIT (NYSE:ARR) has clearly seen better days. The stock was once a favorite among income oriented investors due to its high yield and monthly dividends. Earlier in the year I had warned investors to avoid Armour due to its use of excessive leverage and underperformance compared to its peers. This call turned out to be mostly correct as Armour's stock price has since been hammered, down about 35%, largely as a result of the Feds tapering announcement. Armour has announced monthly dividends of $0.07 per share through September, which equates to a 20% yield at current prices.

Have Book Value Declines Moderated?

As shown below, Armour's book value has been absolutely decimated in recent quarters. From a high of $7.77 per share back in Q3 2012 to the current $5.43 per share, this represents a 30% drop. This decline is mostly the work of Armour's leverage plus premiums paid for MBS. Do note that Armour is not alone among mREITs in seeing large book value declines. Indeed, all mREITs have suffered as the current Treasury bear market is the worst since 1994.

It is rather difficult to estimate Armour's current book value. It most likely has declined from the June 2013 quarter book value of $5.43, with MBS prices moving lower. However, they have recently started to become somewhat decoupled from treasury prices. Do note that book values for mREITs are a moving target and are greatly impacted by news events. That being said, I think Armour's book value is still above the current share price.

Armour's NIM appears to have bottomed

The net interest spread times leverage is essentially how mREITs make their money. Unfortunately for shareholders, Armour's net interest margin, or NIM, has declined greatly in 2013.

In Q2 2013, Armour generated about $91.4M in estimated taxable REIT income and paid out dividends of $78.7M. REITs typically pay out at least 90% taxable REIT income in order to maintain its tax qualification as a REITs. Core income, which gives a more accurate picture of Armour's profitability, was about $69.9M. Armour's NIM was about 1.38% in the quarter, a slight improvement from the 1.35% last quarter. Armour's ROE was about 13.5% on an annualized basis.

If there was any upside to weakening of MBS prices for Armour, it would have to be higher spreads. Armour should be able to maintain its NIM, or even increase it, as long as its cost of funds remains relatively flat. Armour usually announces its monthly dividends quarterly (3 months at a time). It will be interesting to see what Armour's new monthly dividend is, as it will give us a better gauge into its current quarter profitability. Considering its current yield of over 20%, I think the market may be factoring in a dividend reduction.

Armour's Leverage Remains High

One might wonder how Armour was able to generate a 13.5% ROE with only a 1.38% spread. The answer is simple -- leverage. Armour's number one risk is its high leverage ratio, which was around 9.77X as of June 30 2013. This leverage ratio is one of the highest among mREITs, with typical leverage ratios ranging from 6X to 8X.

IMO, Armour's leverage ratio is absurdly high. It almost seems to be an attempt to generate income at any cost, regardless of the effect on book value. Armour was impacted by the collapse in MBS primarily due to its sky-high amounts of leverage.

Downside Catalyst: Increasing Share Count and Dilution

In my prior article, one of the main issues that I had with Armour was its frequent dilution of shareholders via frequent secondary offerings. Since 2012, Armour has more than tripled the number of shares it has outstanding.

As a result, Armour's total shareholder equity has surged to more than $2.2B as of June 30 2013. Do note that before the reason share value decline, shareholder equity was at one point over $2.7B.

Armour's increasing share count and shareholder equity has not really benefited shareholders. However, Armour's management does seem to have received a windfall. Below is a quote from Armour's current management fee agreement from its SEC filing:

The 2012 Management Agreement entitles ARRM to receive a management fee payable monthly in arrears. Currently, the monthly management fee is 1/12th of the sum of (NYSE:A) 1.5% of gross equity raised up to $1 billion plus (NYSE:B) 0.75% of gross equity raised in excess of $1 billion. The cost of repurchased stock reduces the amount of gross equity raised used to calculate the monthly management fee.

For the June 2013 quarter, Armour's effective management fee was $7.87M, or 1.016%, based on gross equity raised. This is an 83% increase from $4.30M last year and a 16% increase from $6.63M last quarter. As shown below, Armour's management fees have steadily increased every quarter.


Considering its lackluster YTD performance compared to peers, interest rate risk, MBS market volatility, and negative total returns, Armour is still a stock I would avoid. Armour is most certainly cheap, trading at a substantial 23% discount to book value. However, it is cheap for a reason -- it is a classic value trap.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long CYS and AGNC