American Capital Agency's Dividend Sustainability Analysis (Post Q1 2014 Earnings) - Part 1

May.22.14 | About: American Capital (AGNC)

Summary

American Capital Agency reported estimated REIT taxable income (‘ERTI’) to common shareholders of $167 million (or $0.47 per common share) for the first quarter of 2014.

AGNC had a quarterly ERTI underpayment (overpayment) of ($65) million and a quarterly payout ratio of 139%.

AGNC’s "cumulative undistributed taxable income ('UTI') coverage of quarterly dividend distributions" ratio fell from a factor of 0.90 as of 12/31/2013 to a factor of 0.63 as of 3/31/2014.

American Capital Mortgage reported ERTI to common shareholders of $31.1 million (or $0.61 per common share) for the first quarter of 2014 with a quarterly payout ratio of 107%.

Part 2 will discuss some additional topics/trends to consider in a general net rising (and falling) interest rate environment regarding AGNC’s, MTGE’s, and Annaly Capital Management’s dividend sustainability.

Author's Note: This two-part article is a very detailed look at AGNC's dividend sustainability. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized conclusions/results, I would suggest to scroll down to the "Conclusions Drawn" section at the bottom of each part of the article.

Focus of Article:

The focus of this article is to provide a detailed analysis with supporting documentation (via two tests) on the dividend sustainability of American Capital Agency Corp. (NASDAQ:AGNC). I am writing this particular article due to the continued high demand that such an analysis be performed. This analysis will be provided after a brief overview of AGNC's operations including a discussion of AGNC's real estate investment trust (REIT) classification per the Internal Revenue Code ('IRC'). Understanding the tax and dividend payout characteristics of AGNC will provide investors with an overall better understanding of the mortgage real estate investment trust (mREIT) sector as a whole. Due to the fact AGNC has produced an annual dividend yield of at least 11% since the company's inception in 2008, many investors have chosen this stock (including other stocks within the mREIT sector) for income-producing equity investments. From reading this article, investors will better understand how a qualified REIT entity per the IRC comes up with the company's current dividend rate and specific signs when an impending dividend raise or cut would be implemented.

I will be performing two dividend sustainability tests within this article. These two tests will be termed "TEST 1" and "TEST 2." This will also include a brief discussion of AGNC's sister company American Capital Mortgage Corp. (NASDAQ:MTGE) and the company's closest sector peer Annaly Capital Management, Inc. (NYSE:NLY) regarding the same general metrics. After these two tests are analyzed, some recent topics/trends to consider in a general net rising (and falling) interest rate environment will also be discussed. These trends will have a direct impact on AGNC's future dividend sustainability and therefore should also be addressed. At the end of this article, there will be a conclusion on my personal opinion about the overall dividend sustainability of AGNC for several upcoming quarters. A specific analysis of AGNC's dividend range scenarios for the second quarter of 2014 will be discussed in a future article next month.

Due to the length of the material covered in this article, I feel it is necessary to break AGNC's dividend sustainability analysis into two parts. This article will be broken-down by the following categories:

PART 1:

- AGNC's REIT Classification per the IRC

- Estimated REIT Taxable Income ('ERTI') Overview

- TEST 1: Analysis and Results

- TEST 2: Analysis and Results

- Brief Discussion of MTGE's and NLY's Dividend Sustainability (When Compared to AGNC):

PART 2:

- Additional Topics/Trends to Consider in a General Net Rising (and Falling) Interest Rate Environment Regarding AGNC's Dividend Sustainability

- Brief Discussion of Additional Topics/Trends to Consider in a General Net Rising (and Falling) Interest Rate Environment Regarding the Dividend Sustainability of MTGE and NLY

Side Note: I recently wrote a three-part article on AGNC where I projected the company's income statement for the first quarter of 2014. In a second article, I projected AGNC's book value ('BV') as of 3/31/2014. These two sets of articles set the foundation for understanding certain types of account descriptions and figures shown in several tables within this article's dividend sustainability analysis. As such, it would be wise for new readers to first read my previous articles to gain a better understanding of AGNC's accounts and how certain figures are derived. The following links are to my recent AGNC income statement and BV projection articles:

American Capital Agency's Upcoming Q1 2014 Income Statement Projection (Part 1)

American Capital Agency's Upcoming Q1 2014 Income Statement Projection (Part 2)

American Capital Agency's Upcoming Q1 2014 Income Statement Projection (Part 3)

American Capital Agency's Upcoming Q1 2014 Book Value Projection

Discussion of AGNC's REIT Classification per the IRC:

Since I have previously discussed this topic in past AGNC dividend sustainability articles, this section of the article will be omitted to reduce redundancy. The link to a prior quarter's dividend sustainability article is provided below:

American Capital Agency's Dividend Sustainability Analysis (Post Q3 2013 Earnings) - Part 1

Estimated REIT Taxable Income ('ERTI') Overview:

- See Red References "A, B, C, D, E" in Table 1 Below Next to the March 31, 2014 Column

Before we begin AGNC's dividend sustainability analysis, let us briefly get accustomed to the information provided by the company in Table 1 below. Table 1 is the equivalent to AGNC's quarterly shareholder presentation slide called "Reconciliation of Generally Accepted Accounting Principles ('GAAP') Net Income to Estimated Taxable Income." Table 1 below shows AGNC's ERTI from the first quarter of 2014 going back to the second quarter of 2013. All figures within Table 1 are for the "three-months ended" (quarterly) time frame.

Table 1 - AGNC Quarterly ERTI Analysis

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(Source: Table created entirely by myself, partially using data obtained from AGNC's quarterly investor presentation slides)

Since I have previously discussed what accounts/figures comprised Table 1 above in past AGNC dividend sustainability articles, such descriptions will be omitted from this article to reduce redundancy. My past dividend sustainability articles highlight what comprises each red referenced figure and the impacts on AGNC's quarterly ERTI / annual REIT taxable income ('AREITTI'). The link to a prior quarter's dividend sustainability article is provided below:

American Capital Agency's Dividend Sustainability Analysis (Post Q4 2013 Earnings) - Part 1

Due to the specific IRC provision stating an entity must distribute at least 90% of its AREITTI to retain the company's qualified REIT status, AGNC mainly bases the current and future dividend per share amounts upon this figure. However, this is not the only figure AGNC bases the company's quarterly dividend distributions on. With that being said, this figure is still an extremely important indicator regarding MINIMUM annual distribution requirements ('ADR'). Now let us perform AGNC's dividend sustainability analysis. This analysis will be a good general indicator of AGNC's current dividend sustainability for the foreseeable future (next several quarters) including whether an impending dividend raise or cut could eventually come to fruition.

Side Note: There are several other indicators and calculations that can help assist or add to one's viewpoint on the dividend sustainability of a company. Some analysts like to prepare some kind of discounted cash flow or "true earnings" analysis based solely on cash. With other sectors or even other mREIT companies, I would tend to agree with this notion. However, AGNC's management team provides to the public quarterly ERTI figures. Most companies do not provide such disclosures to the public because quarterly ERTI is a non-GAAP measurement (not an SEC requirement). AGNC's ERTI calculation basically converts the company's quarterly net income (loss) per GAAP into the company's taxable net income (loss) per the IRC. Since AGNC provides this valuable information to the public, I feel a discounted cash flow or true earnings analysis is "trumped" by the quarterly ERTI figure. Since AGNC is classified as a qualified REIT entity per the IRC, the company must distribute 90% of its AREITTI in a given calendar year (disregarding the spillback provision). Management has consistently stated the company bases AGNC's quarterly dividend distributions upon the quarterly ERTI/AREITTI and cumulative undistributed taxable income ('UTI') figures. Using this methodology, I have correctly projected (within range or the exact per share amount) AGNC's quarterly dividend distributions for the past seven quarters. Therefore, I feel TEST 1 and TEST 2 below will be a good "starting point" for an overall dividend sustainability analysis. As will be discussed within PART 2 of this article, this specific methodology will slightly change in the second quarter of 2014 due to a recent strategy that has once again been implemented by management.

TEST 1 - Quarterly ERTI - Common Shareholders Versus Quarterly Distributions Analysis:

- See Red References "E, G, H" in Table 2 Below Next to the March 31, 2014 Column

Before we begin TEST 1 of AGNC's dividend sustainability analysis, let us first briefly get accustomed to the information provided in Table 2 below. Table 2 is an extension of the information provided in Table 1 above. Table 2 below shows AGNC's ERTI from the first quarter of 2014 going back to the company's second quarter in 2013. All figures within Table 2 are for the "three-months ended" (quarterly) time frame. Table 2 below compares AGNC's quarterly ERTI figure to the company's dividend distributions figure and then shows the quarterly underpayment (overpayment).

Table 2 - AGNC Quarterly ERTI - Common Shareholders Versus Quarterly Distributions Analysis (TEST 1)

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(Source: Table created entirely by myself, partially using AGNC data obtained from the SEC's EDGAR Database)

AGNC does not provide a table that is comparable to the bottom portion of Table 2 (see red references "G, (E - G) = H, G / E" in Table 2 above). As such, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 2 above. I have gathered specific information derived from multiple tables/charts for a more detailed analysis of AGNC's dividend sustainability. Let us briefly describe the new accounts shown within Table 2 above that were not included in Table 1 shown earlier in the article.

G) Distributions to Shareholders from ERTI:

- See Red Reference "G" in Table 2 Above Next to March 31, 2014 Column

These figures represent the quarterly accrual AGNC makes in regards to the company's dividend distributions to common shareholders. This accrual is made in the current quarter and paid the following quarter. Through research, one can calculate these quarterly amounts via disclosed data within the SEC's EDGAR Database.

H) Underpayment (Overpayment) of ERTI:

- See Red Reference "H" in Table 2 Above Next to the March 31, 2014 Column

These figures represent the quarterly underpayment (overpayment) of AGNC's ERTI when compared to the company's dividend distributions to common shareholders.

Table 2 also includes what percentage of quarterly ERTI is paid out in the form of dividend distributions for additional clarity and insight (see red reference "G / E" in Table 2 above). Again, AGNC does not provide this specific information. However, one can calculate the percentage of AGNC's quarterly underpayments (overpayments).

TEST 1 - Analysis and Results:

Using Table 2 above as a reference, I take AGNC's quarterly "ERTI - common shareholders" figure (see red reference "E" in Table 2 above) and subtract this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "G" in Table 2 above). If AGNC's red reference "E" is greater than the company's red reference "G," then AGNC technically has enough quarterly ERTI to pay out the company's dividend distributions for a particular quarter. As such, any excess quarterly ERTI left over (after accounting for the dividend distributions) would be added to AGNC's cumulative UTI balance. UTI will be further discussed within TEST 2 later in the article. If AGNC's red reference "E" is less than the company's red reference "G", then AGNC has currently overpaid the company's quarterly dividend distributions and must use a portion of the remaining cumulative UTI balance to help pay for the overpayment.

First Quarter of 2014 Dividend:

As I correctly projected in the prior quarter's dividend sustainability article (see link above), I concluded the stronger quarterly ERTI figure for the fourth quarter of 2013 resulted in a "leveling-off" of the deterioration of AGNC's dividend sustainability. Due to a slight decline in the aggressiveness of AGNC's derivatives portfolio (along with MBS price increases), I correctly projected AGNC would maintain the company's dividend at $0.65 per share in the first quarter of 2014.

This projection was provided via my dividend range scenarios for the first quarter of 2014 article. As such, when AGNC declared an unchanged dividend for the first quarter of 2014, I was not surprised. In fact, the dividend of $0.65 per share was exactly at the median of my projected dividend range. For many AGNC shareholders, this was "welcome" news as it was the first time in three quarters the dividend was not cut. AGNC also repurchased 3.4 million outstanding shares of common stock during the first quarter of 2014 at a material discount to BV.

Still using Table 2 above a reference, for the first quarter of 2014 AGNC reported quarterly ERTI of only $0.47 per share. Personally, this was bit of a disappointment when compared to my projected ERTI (towards the lowest-end of my range). This was due to the fact management continued to aggressively decrease AGNC's "on balance sheet" MBS portfolio. This topic will be further discussed in PART 2 of this article.

When compared to the prior quarter, the first quarter of 2014 saw a modest (some could argue material) decrease in AGNC's quarterly ERTI figure. For the first quarter of 2014, AGNC had ERTI available to common shareholders of $167 million. However, AGNC distributed ($232) million of dividends. This equated to an underpayment (overpayment) of ($65) million and a payout ratio of 139%. When compared to the payout ratios for the second and fourth quarters of 2013, this quarterly payout ratio would be seen as a negative sign.

From looking at the results from TEST 1, the odds of AGNC being able to maintain the company's current dividend of $0.65 per share have slightly decreased when compared to the prior quarter.

However, there were several reasons for this decrease that readers should understand before "passing judgment" on the quarter. These reasons will be discussed in PART 2 of this article.

When combining results from TEST 1, along with conclusions drawn from my recent articles, a good foundation is formed on AGNC's recent performance regarding the company's quarterly ERTI. However, TEST 1 does not come with certain drawbacks and limitations. This is why I believe additional analysis should be performed within this article. TEST 1 does not specifically account for AGNC's cumulative UTI balance (which will be discussed in TEST 2 below) or any future topics/trends to consider (which will be discussed in PART 2 of this article). Since TEST 1 does not specifically include these additional factors, it would only be prudent to now perform TEST 2 and see if similar results can be ascertained. TEST 2 needs to be performed to gain further clarity on AGNC's future dividend sustainability in the upcoming quarters.

TEST 2 - Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis:

- See Red References "I, J, K" in Table 3 Below Next to the March 31, 2014 Column

Before we begin TEST 2 of AGNC's dividend sustainability analysis, let us first get accustomed to the information provided in Table 3 below. Table 3 is an extension of the information provided in Table 2 above. Table 3 below shows AGNC's dividend distributions from the first quarter of 2014 going back to the company's second quarter in 2013. Table 3 also shows AGNC's quarterly underpayment (overpayment) of the company's ERTI (discussed in Table 2 and TEST 1 above). Table 3 below then compares AGNC's quarterly dividend distributions to the company's cumulative UTI balance for the same quarter. All figures within Table 3 are for the "three-months ended" (quarterly) time frame except for AGNC's cumulative UTI balance. The cumulative UTI figure is a "running balance" that either increases or decreases each quarter as AGNC underpays (overpays) the company's quarterly dividend distributions.

Table 3 - AGNC Cumulative UTI Coverage of Quarterly Dividend Distributions Ratio Analysis (TEST 2)

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(Source: Table created entirely by myself, partially using AGNC data obtained from the SEC's EDGAR Database [link provided below Table 2])

AGNC does not provide a table that is comparable to Table 3 (see red references "I, J, (J / G) = K" in Table 3 above). As such, there will not be an identical sheet AGNC provides that matches the data I have prepared in Table 3 above. I have gathered specific information derived from multiple tables/charts for a more detailed analysis of AGNC's dividend sustainability. Let us briefly describe the new accounts shown within Table 3 that were not included in Table 2 shown earlier in the article.

I) Cumulative UTI Recalculation; and J) Cumulative UTI Balance:

- See Red References "I, J" in Table 3 Above Next to the March 31, 2014 Column

UTI is the cumulative running balance of AGNC's past undistributed ERTI after management accrues for the company's quarterly dividend distributions. The cumulative UTI balance increases if AGNC's quarterly ERTI figure is more than the accrued quarterly dividend distributions figure. The cumulative UTI balance decreases if AGNC's quarterly ERTI figure is less than the accrued quarterly dividend distributions figure.

TEST 2 - Analysis and Results:

Using Table 3 above as a reference, I take AGNC's "cumulative UTI" figure (see red reference "J" in Table 3 above) and divide this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "G" in Table 3 above). From this calculation, AGNC's "cumulative UTI coverage of quarterly dividend distributions ratio" is obtained (see red reference "K" in Table 3 above). This can also be referred to as AGNC's "UTI per share" amount. The higher this ratio (or per share amount) becomes, the more positive the results regarding AGNC's future dividend sustainability. Basically, this ratio/per share amount shows the amount of cumulative UTI covering the current quarter's dividend distributions (after taking the current quarter's dividend distributions accrual into account).

As was the case with TEST 1, TEST 2 showed a few negative signs during AGNC's first quarter of 2014. As of 12/31/2013, AGNC reported a cumulative UTI balance of $210 million. This balance was reduced to $146 million as of 3/31/2014. As such, there was a modest (some could argue material) cumulative UTI decrease during the first quarter of 2014. Due to the fact there was only a minor repurchase of outstanding shares of common stock during the first quarter of 2014, AGNC still needed to achieve the relatively same quarterly ERTI "break-even" when compared to the prior quarter. Instead of having to achieve quarterly ERTI of $235 million before breaking-even within the cumulative UTI balance, AGNC still needed to achieve quarterly ERTI of approximately $232 million to break-even.

However, if AGNC were to continue repurchasing outstanding shares of common stock in future quarters (strong possibility in the current environment), the company's quarterly cumulative UTI break-even would continue to gradually decrease even if quarterly dividend distributions remained at $0.65 per share. Since AGNC's current stock price continues to trade modestly lower than the company's stated BV of $24.49 per share as of 3/31/2014 (and more importantly CURRENT BV), additional equity raises will not occur (extremely low probability; dilution of BV). As such, AGNC's quarterly cumulative UTI break-even should not materially increase over the foreseeable future. Strictly on a cumulative UTI break-even basis, this spells good news for AGNC's dividend sustainability.

With that being said, when AGNC reported a weak quarterly ERTI figure of $0.47 per share for the first quarter of 2014 (as mentioned in TEST 1 above), TEST 2 also began showing signs of stress in regards to AGNC's dividend sustainability. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio fell from a factor of 0.90 as of 12/31/2013 to a factor of 0.63 as of 3/31/2014. AGNC's results for the first quarter of 2014 were negative regarding TEST 2. As mentioned in TEST 1 above, AGNC had a quarterly overpayment of ($65) million in the first quarter of 2014. Such an overpayment caused AGNC's cumulative UTI balance to lose approximately 30% of the company's remaining surplus balance within three months.

From looking at the results from TEST 2, the odds of AGNC being able to maintain the company's current dividend of $0.65 per share have slightly decreased when compared to the prior quarter. However, PART 2 will discuss some recent topics/trends that may partially counter the evidence obtained within both TEST 1 and TEST 2 above.

Brief Discussion of MTGE's and NLY's Dividend Sustainability (When Compared to AGNC):

Using Table 4 below as a reference, let us briefly compare AGNC to its sister company MTGE regarding TEST 1 and TEST 2.

Table 4 - AGNC Versus MTGE Dividend Sustainability Analysis (TEST 1 and TEST 2)

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(Source: Table created entirely by myself, partially using AGNC and MTGE data obtained from the SEC's EDGAR Database [link provided below Table 2])

Let us first discuss TEST 1. Using Table 4 above as a reference, when compared to AGNC, MTGE had a better quarterly ERTI per share figure for the first quarter of 2014. AGNC had quarterly ERTI of $0.47 per share (as mentioned in TEST 1 above) while MTGE had quarterly ERTI of $0.61 per share. AGNC had a quarterly overpayment of ($65.0) million while MTGE had a quarterly underpayment of only ($2.2) million for the first quarter of 2014. When calculated, this translated to AGNC having a quarterly payout ratio of 139% (as mentioned in TEST 1 above) while MTGE had a quarterly payout ratio of 107%. Therefore, I believe MTGE outperformed AGNC regarding TEST 1.

Now let us discuss TEST 2. Still using Table 4 above as a reference, MTGE's cumulative UTI coverage of quarterly dividend distributions ratio was much better as of 3/31/2014. AGNC's cumulative UTI coverage of quarterly dividend distributions ratio was a factor of 0.63 (as mentioned in TEST 2 above) while MTGE's ratio was a factor of 1.12 as of 3/31/2014. Therefore, I believe MTGE is currently in better shape regarding future dividend sustainability when compared to AGNC.

Additional comparisons between AGNC and MTGE regarding future dividend sustainability will be provided in PART 2 of this article.

Just like AGNC and MTGE, NLY was able to stabilize the company's dividend during the first quarter of 2014. Since NLY continued to cut its quarterly dividend throughout various quarters during the past several years, the probability of the company being able to maintain the dividend at $0.30 per share had modestly increased. This is mainly due to the material decrease in NLY's quarterly dividend distributions' break-even amount.

However, when NLY reported weak quarterly core earnings (the company's taxable income equivalent) of $0.23 per share for the first quarter of 2014, signs of stress also rose once again in regards to NLY's future dividend sustainability. While AGNC had a quarterly ERTI underpayment (overpayment) of ($0.17) per common share when compared to quarterly dividend distributions of $0.65 per common share, NLY had a quarterly core earnings shortfall of ($0.07) per common share when compared to quarterly dividend distributions of $0.30 per common share. Proportionally speaking, both overpayments were pretty similar. When calculated, AGNC and NLY had quarterly payouts of 139% and 128%, respectively.

Conclusions Drawn (PART 1):

To sum up all the information in PART 1 of this article, TEST 1 showed AGNC had ERTI available to common shareholders of $167 million for the first quarter of 2014. However, AGNC distributed ($232) million of dividends. This equated to an underpayment (overpayment) of ($65) million and a payout ratio of 139%. From looking at the results from TEST 1, the odds of AGNC being able to maintain the company's current dividend of $0.65 per share have slightly decreased when compared to the prior quarter.

TEST 2 showed any future material overpayments of AGNC's quarterly ERTI would cause the company's cumulative UTI balance to be further reduced to a relatively low level. AGNC had used up a material portion of the company's cumulative UTI balance during 2013 and continued this trend during the first quarter of 2014. TEST 2 showed if AGNC continued to have modest overpayments of the company's quarterly ERTI when compared to the current quarterly dividend distributions break-even figure of $232 million, this modest deficit could be offset by AGNC's cumulative UTI balance of $146 million as of 3/31/2014 for only a few more quarters before becoming a deficit balance. Another negative sign was that AGNC's cumulative UTI coverage of quarterly dividend distributions ratio decreased from a factor of 0.90 as of 12/31/2013 to 0.63 as of 3/31/2014.

From the data presented above regarding TEST 1 and TEST 2, there seems to be a few negative signs regarding AGNC's dividend sustainability for the upcoming quarters. As concluded from both TEST 1 and TEST 2, if AGNC has a materially weak quarter or several modestly weaker quarters regarding ERTI, AGNC's future dividend sustainability at the $0.65 per share level will "seem" to be in jeopardy.

From looking at the results from TEST 1 and TEST 2, the odds of AGNC being able to maintain the company's current dividend of $0.65 per share have slightly decreased when compared to the prior quarter. However, PART 2 will discuss some recent topics/trends that may partially counter the evidence obtained within PART 1 of this article.

Final Note: Based on the results shown in TEST 1 and TEST 2 above, I feel it is only prudent to include additional analysis regarding AGNC's future dividend sustainability. As such, PART 1 of this article is only a PARTIAL analysis of AGNC's dividend sustainability over the foreseeable future. Therefore, a "full" conclusion regarding AGNC's dividend sustainability will not be provided yet. PART 2 of this article will just pick up where PART 1's analysis ends. PART 2 of this analysis will discuss some additional topics/trends to consider in a general net rising (and falling) interest rate environment. I feel the following four topics/trends (which includes one brand new topic/trend) should be addressed regarding a general net rise (and drop) in mortgage interest rates/U.S. Treasury yields and the impact on the future dividend sustainability of AGNC: 1) continued realignment of the company's MBS portfolio; 2) hedging costs (in particular periodic interest costs on interest rate swaps); 3) taxation impact of realized losses on MBS sales; and 4) taxation impact of a net long TBA MBS position. PART 2 of this article will be available to readers next week.

Disclosure: I am long AGNC, MTGE. 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. I have no position in NLY.