ARMOUR Stands Out With Significant Price Appreciation Potential And Attractive Dividend Yield

Jul.11.14 | About: ARMOUR Residential (ARR)

Summary

Company has been taking the right measures in the ongoing industry environment.

ARR has been repositioning its portfolio by favoring 15-year MBS to protect its book value.

Portfolio repositioning should reduce rate sensitivity moving forward.

Stock offers impressive total return of 23%.

The net spread earned and book values of mREITs were negatively affected by rising and volatile treasury yields in 2013. In the first half of 2014, treasury yields have remained relatively stable, which will portend well for book values of mREITs. MREITs are also effectively repositioning their investment portfolios to safeguard their book values. Moreover, valuations and book values of mREITs will benefit from a systematic end to the Fed's bond purchases and a stable Federal Funds rate until H2 2015. I am bullish on Armour Residential REIT (NYSE:ARR); the company invests in hybrid, adjustable and fixed rate mortgage securities whose interest and principal payments are backed by the U.S. government. Consistent with the current yield environment and potential increase in treasury yields, the company has been repositioning its portfolio, favoring 15-year securities. Also, I believe the return potential remains attractive and will compensate investors well for the risk of the volatile rate environment; the stock offers a high dividend yield of 14.1% and potential price appreciation of 9%.

ARR has being taking correct measures to protect its book value by repositioning its portfolio, mainly by shortening the duration of assets. Also, the company has been managing its leverage to address the risk in uncertain conditions. In an attempt to reduce asset duration profile, the company has rotated out of 30-year MBS into mainly 15-year sector in recent months. Also, the company is hedged 66% with interest rate swaps.

The company sold $5.6 billion of agency securities and closed its entire 25-year agency MBS position in Q1 '14. Also, in April, ARR sold the remaining $1.2 billion of 30-year agency MBS. ARR rotated into 15-year MBS to lower its book value risk in case of rate volatility and spread widening in the future. The company's investment portfolio has gone through significant changes since the end of Q4 '13, evident from the fact that 30-year MBS was 42% of the portfolio by the end of Q4 '13, which the company has completely eliminated in Q2 '14. Also, 15-year MBS as a percentage of portfolio has increased from 20% in Q4 '13 to the current level of approximately 69%. 99% of the company's portfolio is invested in fixed rate MBS and 70% of the fixed rate portfolio has maturities between 10 years and 15 years, while 28% of the portfolio has maturities between 15 and 20 years.

The company still has some curve twist exposure; however, the portfolio repositioning and duration shortening will protect ARR's book value well against parallel shifts in the yield curve. Moreover, I believe ARR's book value is positively exposed to the 10-year yield moving slightly up, and the 3-year and 5-year issue yields slightly lowering.

Also, net spread increased by 0.22% quarter-on-quarter to 1.82% in Q1 '14, mainly due to higher yields on assets (up 0.21% to 3.19%) as a result portfolio rebalancing.

Dividends and Share Repurchases
ARR remains one of the most attractive dividend yields in the mREITs space; it offers a dividend yield of 14.1%. I foresee ARR's earnings covering the dividend, and the current dividend rate being sustainable in the future. ARR has announced to pay a monthly dividend of $0.05 through the end of 2014; the company recently confirmed a monthly dividend of $0.05 per share for Q3 '14.

The company's share count as of 9th June 2014 was 357 million, down 0.5 million from 10th February 2014. In March, the company's board authorized share repurchases of up to $100 million and 50 million shares. The company repurchased 4% of total shares outstanding in Q4 '13, taking advantage of depressed valuations, as the stock was trading below its price-to-book value of 0.80x. In the future, I believe the company will continue to repurchase shares to benefit from depressed valuations, as the stock is currently trading at a price-to-book value of 0.82x.

Conclusion and Valuation

I believe that ARR, along with other mREITs, will experience multiple expansion as the treasury yield environment stabilizes. The stock is currently trading at a price-to-book value of 0.82x, lower than its historical price-to-book value of approximately 1x. Given the risk of rate volatility, I have applied a 10% discount to ARR's historical price-to-book value of 1x for calculation of a price target.
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I have calculated a price target of $4.70 for ARR, using the current book value of $5.23 and targeted price-to-book value of 0.90x. The stock offers a potential price appreciation of 8.8% and a total potential return of 23%, including a high dividend yield of 14.1%. The following table shows price target calculations for ARR.

Current Book Value

Target Price to Book Value

Price Target

$5.23

0.90x (1*(1-0.1))

$4.70

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The company has been taking the right measures in the ongoing industry environment. ARR has been repositioning its portfolio, favoring 15-year MBS, to protect its book value, which tightens up the duration gap. Also, portfolio repositioning should reduce rate sensitivity moving forward. Moreover, the stock offers an impressive total return of 23%, including potential price appreciation of 8.8% and a dividend yield of 14.1%.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.