CYS Investments (NYSE:CYS) reported its second quarter's earnings on July 21, 2014 and failed to meet analyst expectations of $0.34 per share. I reiterate my neutral stance on the company because it continues to position its portfolio defensively. Furthermore, CYS has also increased its hedge positions, which are not consistent with the current interest rate scenario. However, I am expecting a modest price appreciation of 3% as the book value has improved in the last quarter.
Continued Pressures on Core EPS
In my previous article on the company last week, I estimated CYS would slightly miss earnings expectations due to high CPR and Net Interest Margin [NIM]. My estimates were correct. The company's core EPS reached $0.21 per share, which means a drop of $0.07 per share as compared to the first quarter of the year. The reasons behind the decline were the same that I had mentioned, namely lower NIM and high CPR.
NIM, as expected, declined 27bps form the prior quarter. Asset yield declined by 37bps, which was due to the company's shifts towards low yielding treasury securities. The company has slightly changed its strategy in the second quarter and increased its allocation to 30-year MBS by $0.4 billion, but on the other hand it has also increased its exposure to treasuries by $0.5 billion.
CYS has also taken some correct steps. The management mentioned that so far in the third quarter the yield has increased by 10-15 bps, which will be because of the additional purchase of $1.4 billion of 30-year MBS, subsequent to the end of the second quarter. In the current quarter, the company has also sold $1.15 billion of treasury securities. Also, I believe the management should look to diversify its portfolio to enhance its risk return profile.
CPR also increased by 200bps, which increased the amortization premium by $0.80 million in the second quarter. However, a worrying sign for investors is the high CPR of 10.8% for the month of July. It will again pressurize core EPS for the current quarter.
However, the drop in core earnings was partially offset by better-than-expected results in drop income. It was $0.05 per share higher than the previous quarter. CYS continued to increase its exposure in the forward settling market and it has reached 17% as compared to 12% in the previous quarter.
I failed to understand the company's hedging strategy. CYS increased its notional principal of swap to $7.3 billion in 2Q as compared to $5.8 billion in the previous quarter. The Fed is continuing with its expansionary monetary policy, which means short term rates are expected to remain stable. Furthermore, the Fed has also given a clear indication of two catalysts that could increase the rates earlier than expected. The two catalysts are wage increases and an increase in labor force participation. In my opinion, CYS could afford to reduce its hedge positions for now, which could reduce costs and hence support the core EPS.
Dividends and Valuations
The company's core EPS and dollar income combined are marginally above the $0.32 quarterly dividends. Core EPS alone is $0.21, which is significantly below dividends. This paints a discouraging outlook for investors. The company needs to invest in high yielding assets to support its core EPS and better manage its dividends. Currently, there is no risk of a dividend cut, but if the management continues with its defensive approach in the period of low interest rate volatility, then investors could expect a dividend cut in coming quarters.
CYS' book value increased by $0.65 per share and reached $10.31 by the end of the second quarter. So, I am raising my price target to $9.27, which is based on my previous discount of 10% to the book value. The new price target dictates a modest price appreciation of 3%.
The company needs to give up on its defensive approach and divert its resources to high yielding assets. CYS has taken the initiative of purchasing 30-year MBS subsequent to the end of the second quarter. This is a step in the right direction, but additional similar initiatives should be taken to enhance the asset yield. The company should also re-structure its hedged positions according to the labor market conditions.
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