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

Can we just stop panicking over the decline in American Capital Agency (NASDAQ:AGNC) and the recent dividend cut? I'm going to say something that should be obvious. The share price decline and subsequent dividend cuts have been reactive, not predictive of the future. There is an old saying that the stock market is a leading indicator of things to come 6 months later. Well, I will tell you that this is not the case for individual stocks. If it was, wouldn't shares of AGNC have plummeted from December 2012-February 2013 in anticipation for the recent extreme volatility in interest rates and mortgage backed securities that occurred from May 2013-July 2013? No, it was during this time that mREITs plummeted, not before. So just why are you panicking over the recent dividend cut and the still depressed share price in AGNC? It doesn't make sense. What you need to do is look ahead to what may happen. Sure interest rates have to rise. The key question is, how rapid will they rise? Management of the mortgage real estate investment trusts (mREITs) can adjust to rates that rise steadily but over a period of time. Slowly rising rates are healthy, as it is a sign of strength of an economy. Rapidly rising rates? Not so much. Speaking of rates, have you seen the ten-year lately? Thank the "no taper" announcement.

The No Taper Announcement

The Federal Reserve's "no taper" announcement has caused a drop in the ten year treasury (figure 1) and initially gave a quick bounce to the mortgage real estate investment trusts (mREITs). In fact, the ten-year is now at its lowest point since August.

Figure 1. Yield on The Ten-Year US Treasury, Last 30 Days.

(click to enlarge)

Short-term, this bodes very well for the mREITS. Now, the initial bounce we saw post-announcement was completely short lived, and then the dividend cut announcements came. First, Javelin Mortgage Investment (NYSE:JMI) led out with a significant 35% cut to its monthly dividend on Thursday 9/19. Then the next day (9/20) we learned that both my two favorite mREITs, AGNC and Annaly Capital Management (NLY), again cut their dividends by 12.5% and 24.0%, respectively. While I suspected small cuts were possible and that most of the pain was over, I was a touch surprised by AGNC's cut. This was especially the most recent AGNC Q2 report. Things seemed to be improving. In fact, I think they are. The ten-year is definitely stabilizing for now under 3.0%, sitting at 2.66% right now. Stabilization is exactly what AGNC needs. Most of the pain was from volatile rises in the rates in the last few months. Yes, AGNC cut is dividend, and I will talk more about that below. But it does not mean that things are getting worse. I will admit, this sector is not for the weak stomach type investors. However, everyone needs to stop panicking and realize that if you are in this for the long-term, then you have to trust the management.

In this article, I will help argue why I think things are improving which will help put the new dividend cut in perspective by discussing and comparing the most recent quarter, providing a dividend analysis for AGNC starting from 2011, when most investors I have spoken to first got in and lay out why I believe the bulk of the bleeding is over. Despite my repeated Tweets and Facebook (NASDAQ:FB) posts regarding the sector, I felt compelled to reassure AGNC investors with data to help quell the panic.

There Is a Good Chance The Q3 and Q4 Interest Rate Spread Will Hold, If Not Improve

What have I always said in my mREIT articles? One of the key metrics for these companies is the interest rate spread. In the second quarter, AGNC's spread was essentially stagnant relative to Q1. I thought it would have tanked given the extreme moves in rates. 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%. A minimal decline. 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.

The First Two Months Of Q3 Were Bad, But Finishing Strong, In My Opinion

So, the cost to borrow rose slightly more than the average yield on assets leading to a higher and essentially flat interest rate spread quarter over quarter. Thus, earnings potential as a result of the interest rate spread has remained the same. I surmise this trend somewhat continued into Q3 and perhaps related to the spread pressured in early Q3, the dividend was cut. Essentially, I think it was likely that AGNC's spread was narrowing into Q3, but this may have turned around here in September as rates have pulled back and have been stable. Overall, I think that the profit potentials are improving for the sector here in the last month of Q3.

Let's Talk More About The Dividend Cut

I'll be honest. The cut from AGNC had me a bit more concerned than cuts that were made by my other holdings. The primary reason for this concern is that I just do not have enough of a historical performance to compare AGNC with. It is still a young company, only getting started in 2008. Now I will say that the current dividend to be paid will be $0.80 per share and this is a large dividend. However, from where the dividend was last quarter, this cut is massive. The Q2 dividend of $1.05 per share was down 16% from the Q1 dividend of $1.25 per share. The current dividend is now in line with where some of my colleagues were opining it could drop to in Q2. In Q2 they could afford the dividend, although it was tight. I'm concerned with the current cut in that it was a 24% hair cut. Does it mean that AGNC sees Q3 as being a weak earnings period as a result of the action in the first two months of the quarter? One thing I do know is that some of the cash is being used to buy back shares, which will translate to higher earnings per share and less total money that will have to be paid out to shareholders. That is a big positive. But the cut to me signals trouble ahead for Q3 earnings. However, given that rates are down in September, the spread may be widening, and could lead to a very strong start into Q4. At a current share price of $23.60 and a new yield of 13.7%, I think there is now risk to the upside for the share price. Further, those who are in this for the long-term are not down as much as they may think.

(click to enlarge)

Don't Panic - Just Keep Collecting The Dividend And Consider Reinvesting.

AGNC has been paying a hefty dividend since 2008. Many of my readers however complain they bought in and held strong since 2010 or 2011. To see where some of these buys might be, with a worst case scenario analysis, I created table 1 to see how much an investor would be down who got in during December 2010.

Table 1. American Capital Agency's Common Stock Dividend History, Dividends Paid Since 2011.

Ex Dividend Date

Dividend Paid Date

Dividend

12/29/2010

1/27/2011

$1.40

3/21/2011

4/27/2011

$1.40

6/21/2011

7/27/2011

$1.40

9/21/2011

10/27/2011

$1.40

12/20/2011

1/27/2012

$1.40

3/5/2012

4/27/2012

$1.25

6/19/2012

7/27/2012

$1.25

9/19/2012

10/26/2012

$1.25

12/24/2012

1/28/2013

$1.25

3/18/2013

4/26/2013

$1.25

6/26/2013

7/26/2013

$1.05

9/26/2013

10/28/2013

$0.80

Clearly, the stock has paid hefty dividends for the last three years. The dividend at $0.80 is the lowest it has been in the past three years, and wasn't this low since 2008. Ok, so what if someone got in at the highest possible price during December 2010? Let us assume they purchased shares once, not adding to declines or reinvesting any dividends. This unfortunate buyer would have acquired shares then at $29.99 a share on December 22, 2010. Thus, as of the current price of $23.60, this person would be down $6.30 or 21%. That is a real disappointment. However the dividends paid (not counting the $0.80 to be paid in October) total $14.30. Therefore, even the most unlucky buyer is still up $8.00 per share since the time they bought because of the dividends. So, I recommend you stop panicking. Yes, the short-term pain is real. The disappointment of a lower share price from where you may have bought and being paid less to wait for a rebound is a tough pill to swallow. But, what you need to do is keep it in perspective. Be happy to still collect 14%. Take the dividend, or reinvest it. Remember, these stocks work best in tax favored accounts such as IRAs or ESAs.

A Point Regarding 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. When the dividend was announced, AGNC didn't release a book value. Judging by the stated book values of others, it is likely the book value had declined 3%-8% since the last announcement. This is just a rough guess based on the performances of those mREIT companies that did announce a book value at the time of dividend announcements in Q3. Thus, I surmise book value was approximately $23.47-$24.75. Furthermore, with the recent stabilization and declines in the ten year treasury and subsequent benefit to the spread, it is likely book value has rebounded slightly since the announcement. At $23.60 per share, it is likely AGNC is still trading below book value. Stop panicking.

Because The Stock Is Below Book Value AGNC Is Buying Back Shares

I mentioned this above, but upon AGNC's dividend cut announcement, the company also announced that during Q3, it made open market purchases of approximately 11.9 million shares AGNC common stock, or 3% of the outstanding shares as of June 30, 2013. The shares were purchased at an average price of $22.16 per share, including expenses, totaling approximately $263 million. Since commencing a buyback program in Q4 2012, AGNC has purchased approximately 14.8 million shares of American Capital Agency common stock for total consideration of approximately $347 million, including expenses.

Bottom Line

Stop panicking. The dividend cut and decrease in share price in 2013 is disappointing. But we have to give management time to adapt to the new environment. The stock buyback will help future earnings and result in less total dividends being paid out, saving money. Interest rates are stabilizing. In fact, they are down to their lowest levels since August, at least on the ten year. Finally, I show the power of the yield AGNC has paid. Many I speak too have bought in 2010 or 2011. They are panicking. However, they are still ahead on their investments and should take advantage of the decreased share price to reinvest dividends. At the very least, be happy to be paid a still healthy 14% to wait for a rebound.

Source: Stop Panicking Over American Capital Agency