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Summary

  • CYS Investments remains the highest dividend paying company in the industry; paying nearly 15% in dividends annually.
  • CYS was on another level in the first quarter, posting the best economic returns.
  • CYS remains undervalued, trading at 90% of book.
  • CYS reduced leverage, but still had an interest rate spread net of hedge, including drop income of 1.89%.

Introduction

Since I wrote my last article on CYS Investments Inc. (NYSE:CYS), the share price has appreciated by 14%, but in my opinion, CYS still has the best upside potential in the industry. The company has shifted the portfolio composition to better match the current environment. CYS continues to outperform everyone in the industry (not just the average). Plus, the company remains cheap relative to industry peers.

What Has Changed

Book value per share has declined from 10.10 to 9.68, but interest rate spread net of hedge, including drop income, has increased from 1.66% to 1.89%. Adjusted average cost of funds and hedge has decreased from 1.01% to 0.96%, and weighted average CPR has declined from 12.4% to 6.1%. All these variables led to an increase in core earnings from $.23 to $.28. The $.32 dividend the company paid in the first quarter is sustainable.

The company repurchased 5.2 million shares at an average price of $8.28 in the fourth quarter. No further repurchases were made in the first quarter. This makes sense, as the company is no longer trading at a significant discount to book value.

Although it's thought that CYS is more volatile than other companies in the industry, the leverage has been reduced to 6.32. The company has also significantly shifted the portfolio since my last article.

31-Mar-14 30-Sep-13
Fair Value ($ in billions) % of Total Fair Value ($ in billions) % of Total
15-Year Fixed Rate 6.4 48% 6.2 43%
20-Year Fixed Rate 0.1 1% 0.1 1%
30-Year Fixed Rate 3.3 24% 6 42%
Hybrid ARMs 2 15% 2.1 14%
U.S. Treasury Securities 1.5 12% - -%
Total 13.3 100% 13.9 100%

The movement out of 30-Year Fixed Rate suggests that the company believes that interest rates are more likely to start increasing. In fact, listening to the conference call reinforces this.

I strongly suggest you listen to the conference call and look at the Q1 2014 supplemental earnings presentation, because there is some great information; especially the Q&A in the conference call. I really like the way the company has positioned itself. The company is significantly less vulnerable to an increase in interest rates than it was in previous quarters.

CYS vs. Industry

CYS Investments remains the highest dividend paying company in the industry; paying nearly 15% in dividends annually. At a time dividends are in question of dropping even further, CYS is confident in its ability to continue paying the current dividend.

Ticker

Price

Yield

$ 8.67

14.8%

ARMOUR (NYSE:ARR)

$ 4.23

14.2%

American Capital Agency (NASDAQ:AGNC)

$ 23.02

11.3%

Capstead Mortgage (NYSE:CMO)

$ 12.83

10.6%

Anworth Mortgage Asset (NYSE:ANH)

$ 5.33

10.5%

Annaly (NYSE:NLY)

$ 11.51

10.4%

Hatteras Financial (NYSE:HTS)

$ 19.55

10.2%

Average

11.72%

(click to enlarge)

CYS was on another level in the first quarter, posting the best economic returns. The book value increased from $9.24 to $9.68, and it issued a $.32 dividend for an economic return of 8.2%. This occurred while the company shifted its portfolio composition and reduced leverage. Moving forward, I think the company will be able to keep its book value stable, unless there is a significant spike in interest rates over a short period of time.

(click to enlarge)

CYS remains undervalued, trading at 90% of book. The entire industry has traded closer and closer to book value, and I think most companies will trade at or above book value by the end of next quarter. This could be due to a decrease in book value or an increase in share price.

What I also find interesting is the discount that Anworth Mortgage Asset Corp. is trading for. The ongoing proxy battle is definitely impacting share price, but its performance has remained in line with the industry average over the last year.

(click to enlarge)

Annaly Capital Management, Inc. has significantly reduced leverage, and it is having an impact on the company's core earnings. CYS has followed suit, reducing leverage as well, but hasn't seen the shrinking earnings NLY is suffering from. Net interest rate spread was nearly 1% higher for CYS than NLY in the first quarter.

(click to enlarge)

I think this is my favorite graph. Of course, NLY and American Capital Agency Corp. are much bigger than the rest of the industry, but still, the fact they are paid so much is crazy; especially at a time dividends are getting slashed. I wish their performance was tied more to performance instead of AUM. This would drastically change decisions made by the company.

Conclusion

Since my last article, CYS has performed better than I expected. It has also altered the portfolio composition and reduced leverage, putting it in a favorable position going forward. I am keeping my previous price target of $10 and am happy to collect the dividends while I wait. I think the entire industry will continue to trade closer to book value, but CYS will continue to outperform the rest of the industry.

Source: CYS Investments Still Has The Best Upside Potential