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Summary

  • High dividend yield of 14.3% and price appreciation of 5% other key factors for bullish thesis on company.
  • CYS protecting its book value by increasing its exposure to 15-year fixed rate assets in favor of 30-year fixed rate assets.
  • Share buybacks undertaken by company also likely to portend well for earnings and book value.

CYS Investments (NYSE:CYS) is a specialty finance company, which remains attractive for income investors; the company provides a high dividend yield of 14.3%. Mortgage-backed securities are an important component of the company's total investment levered portfolio. I am bullish on CYS, as the company offers a potential total return of approximately 20%, including a high dividend yield of 14.3% and potential price appreciation of 5% (based on my targeted price-to-book value of 1.0x). Also, the company has been taking the right steps to protect its book value by increasing its exposure to 15-year fixed rate assets in favor of 30-year fixed rate assets. And the company has been undertaking share buybacks, which are likely to portend well for the company's earnings and book value.

Financial Performance
Despite the tough business conditions for CYS, the company has reported a satisfactory financial performance. The company reported core plus drop earnings per share of $0.38 (core EPS of $0.31 and drop income per share of $0.07), comfortably covering its current quarterly dividend of $0.32 per share, and doing better than consensus estimates of $0.35 per share. Better-than-expected earnings for the quarter came as a result of an improved asset yield of 2.93%, as compared to 2.67% in 3Q2013. Also, the company was able to improve its costs, and its operating expense ratio dropped to 0.89% in 4Q2013, as compared to 1.13% in 3Q2013. Due to the improved asset yield and lower expenses, the company enjoyed a net spread of 1.67% in the recent fourth quarter, as compared to 1.25% in 3Q2013.

A negative take-away from the recent quarter's earnings release was the fact that despite better earnings in 4Q2013, the company's book value dropped approximately 8.5% quarter-on-quarter to $9.24. The drop in the book value in the recent fourth quarter came as a result of expiration of swap positions and higher leverage; leverage ratio for the company increased quarter-on-quarter from 6.45x to 7.0x. The following table shows the key performance metrics for CYS.

 

Q3 2013

Q4 2013

Earnings Yield on Assets

2.67%

2.93%

Costs of Funds & Hedge

1.01%

1.04%

Interest Spread (Net of Hedge)

1.66%

1.89%

Core - ROAE

12.3%

13.6%

BV Per Share

$10.10

$9.24

Leverage

6.45x

7.0x

Source: Quarterly Report

Portfolio Rebalancing
As Treasury Yields have increased in recent quarters, the company is making efforts to lower its rates sensitivity, which has been negatively affecting CYS' book value; key variables affecting CYS' book value are yield curve steepening and basis risk. The company seems to be aiming to benefit from basis volatility, and is likely to lower its leverage to benefit from mortgage basis widening.

Also, the company reduced its RMBS portfolio to $13.8 billion in 4Q2013, down approximately 5% quarter-on-quarter. In efforts to lower the duration of its RMBS portfolio, CYS decreased its exposure to 30-year fixed-rate assets and increased exposure to 15-year fixed rate assets. In the current yield environment, I believe the company will continue favoring more 15-year fixed-rate assets instead of 30-year fixed-rate assets. The following charts show CYS' portfolio mix for 3Q2013 and 4Q2013.
(click to enlarge)
Source: Company Report

Since the treasury yields started to increase in 2Q2013, the company experienced a drop in the prepayment rate. Prepayments (CPR) for the company dropped to 5.7% in the recent fourth quarter. Due to the current rates environment, amortization is likely to decline, which will portend well for the stock price. The following graph shows CPR for CYS.

Source: Company Quarterly Reports

Dividends and Share Buybacks
CYS currently offers a high dividend yield of 14.3%. I believe dividends offered by the company are sustainable based on its core EPS of $0.31 in 4Q2013 and dividend payout ratio is likely to stay in a range of 85%-100% in the near term. Last week, the company declared a quarterly dividend of $0.32 per share for 1Q2014, flat quarter-on-quarter, and payable on 17 April 2014 to shareholders as of 25 March. The following table shows the quarterly dividends, EPS, payout ratio and book value per share for the recent four quarters.

 

1Q 2013

2Q 2013

3Q 2013

4Q 2013

Dividends Per Share (Quarterly)

$0.32

$0.34

$0.34

$0.32

Total EPS (Core + Drop)

$0.32

$0.37

$0.36

$0.38

Dividend Payout (% of Total EPS)

99%

93%

95%

84%

Book Value Per Share

$12.87

$10.20

$10.10

$9.24

Source: Quarterly Reports and Calculations

The company repurchased 5.2 million shares for $43.4 million in 4Q2013 at a weighted average price of $8.26 per share. The buyback had a positive impact of approximately $0.03 on the 4Q2013 book value. For the full year 2013, CYS repurchased 13.6 million shares at an average price of $8.46 per share. As the current valuations for CYS remain depressed and the stock is trading at a discount, I believe the company will continue its share buybacks in the upcoming quarters, which will have an impact on EPS growth and will magnify ROE.

Conclusion
I believe in the ongoing tough business conditions, the company is taking the correct measures by reducing its exposure to 30-year fixed-rate assets and increasing exposure to 15-year fixed-rate assets. The measure will help CYS protect its book value in the rising yield environment. Also, dividends offered by the company are sustainable, and share buybacks are likely to portend well for earnings growth and the stock price. Moreover, the higher (rising) yield environment provides CYS an opportunity to improve its net interest margin, which will also have a positive impact on the company's future ROE.

Furthermore, the stock offers potential appreciation of approximately 5%, based on my price target of $9.30. The stock has historically traded at a slight premium to its price-to-book value (as shown below). Using historical average price-to-book value of 1.0x and current book value of $9.30, I have calculated price target of $9.30. Due to the abovementioned factors, I have a 'buy' rating on the stock.

The following table shows price target calculation for CYS.

Historical Price-to-Book Value

Book Value

Target Price

1.0x

$9.3

$9.30

The following graph shows historical price-to-book value for CYS.
(click to enlarge)
Source: Ycharts

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.

Source: CYS Investments: Potential Total Return Of 20% Makes An Ideal Buy