- Company taking right steps since the start of the year to protect book value and improve performance.
- AGNC continues to reposition its investment portfolio to protect book value.
- Stock has high dividend yield of 11% and potential price appreciation of 8.5%.
Rising treasury yields negatively affected book values and net spread earned by mREITs in 2013. However, I believe an unchanged Federal Funds rate until the second half of 2015 and a systematic end to Fed asset purchases will support valuations and book values of mREITs in the near-to-medium term. Also, the repositioning of investment portfolios according to the current yield environment will help mREITs protect their book values. I am bullish on American Capital Agency (NASDAQ:AGNC); AGNC invests in securities whose principal and interest payments are guaranteed and backed by the U.S. government. The company's ROE is expected to stay attractive/high as a result of the high spread between asset earning yield and borrowing cost. Also, the company reported a solid financial performance in 1Q14; the solid earnings for the quarter increase my trust in the sustainability of dividend, and I believe the discount to book value will continue to narrow. AGNC currently offers a high dividend yield of 11%.
The company has been taking the right steps since the beginning of the year to protect its book value and improve its performance. AGNC has lowered its leverage to manage risk in an uncertain environment. Also, the company liquidated swaptions at the right time, just prior to the collapse in rate volatility, and purchased shares of other mREITs when valuations were at a deep discount.
The company reported a solid financial performance for 1Q14 and registered a strong start to the year. In 1Q14, core EPS for the company came out to be $0.71, including dollar roll income, $0.02 better than the consensus estimates. Also, in the first quarter, the company's book value increased by 2.3% to $24.49, mainly led by spread tightening in 15-year residential mortgage-backed securities.
Earnings beat in the quarter was driven by dollar roll income. I believe dollar rolls offer strong risk-adjusted return on marginal investment in the current industry environment. We cannot ignore the dollar roll component of earnings, as it occupies capital which otherwise would have generated net interest spread. The company earned dollar roll income of $0.14 as a result of AGNC's $14 billion net long TBA position, which increased from $2.3 billion at the end of 4Q13. If the company had not generated $0.14 in dollar roll income in 1Q14, it would alternately have earned approximately $0.10-$0.12 of net spread income. Therefore, I believe dollar roll income offers good risk-adjusted return in the current industry environment.
The company also continues to reposition its investment portfolio to protect its book value, according to expectations regarding the shape of the yield curve. At the end of 1Q14, the company's MBS portfolio totaled $70.5 billion. 15-year MBS accounted for 48% of the value, down from 51% in 4Q13, whereas 30-year MBS increased from 43% in 4Q13 to 46% of the portfolio in 1Q14. 15-year MBS stays the core of the company's investment portfolio; however, the slight increase in 30-year MBS is consistent with lower spread volatility. The following chart shows AGNC's investment portfolio composition at the end of 1Q14.
Share Repurchases and Dividends
In the current industry environment, share repurchases remain an attractive option in the hands of the management to protect book value and grow EPS. In 1Q14, the company repurchased 3.4 million common stocks at an average price of $22.10 under its $2 billion share repurchase plan, which is set to expire by December 31, 2014, representing almost 1% of shares outstanding at the year-end. There is another $1 billion repurchasing remaining under the $2 billion program. In addition to repurchasing its own shares, the company has been making investments through purchasing equity securities of other mREITs. AGNC's investments across other agency mREITs totaled $352 million by the end of 1Q14. The investments in other mREITs led to earnings of $0.14 per share, or $49 million, in dividend and gains in the quarter. As most of the purchased shares are trading at an approximately 0.9x-to-1x price to book value, AGNC enjoyed gains from price appreciation, subsequent to the purchase of shares at approximately 0.8x. AGNC's share repurchases and investments in other mREITs provide value to investors, as the current valuations of mREITs stay at a discount.
Other than an impressive share repurchase program, the company offers a high dividend yield of 11%. The company recently declared a quarterly dividend of $0.65 per share, payable on July 28, 2014. Also, the solid 1Q14 performance and the higher level of earnings power reflect dividend sustainability; core EPS for the quarter was $0.71, well above the company's quarterly dividend of $0.65 per share.
Valuation and Conclusion
I believe that as the treasury yield environment stabilizes and volatility reduces, AGNC, along with other mortgage REITs, will observe multiple expansion. Currently, AGNC is trading at a price-to-book value of 0.92x, below its historical price-to-book value of more than 1x. The stock will experience multiple expansion and trade at a price-to-book value of 1x (my price-to-book value target).
(click to enlarge)
Using the current book value of $24.51 and the targeted price-to-book value of 1x, I calculate a price target of $24.5 for AGNC. The stock offers potential price appreciation of 8.5% and total returns of 19.5%, including a dividend yield of 11%. The following table shows the calculation for the price target.
Current Book Value
Price to Book Value Target
AGNC has been taking the right measures in the current industry environment. The company has been repositioning its portfolio to protect its book value. The company has been focusing on duration and liquidity; extending duration at a time when extension risk is priced into the market will portend well for the stock. Also, the stock offers a sustainable high dividend yield of 11% and has potential price appreciation of 8.5%, which makes it an attractive investment option.