ARMOUR: Time To Get Going

Aug.29.14 | About: ARMOUR Residential (ARR)

Summary

ARMOUR has been taking the right steps by repositioning its investment portfolio and adjusting its hedge positions to protect book value.

Core EPS will benefit in the future from ARR's measures to reposition its portfolio.

ARR has the option to undertake share repurchases.

Treasury yields in the U.S. in 1H2014 have remained relatively stable, which has positively affected book values and valuations of mortgage REITs (mREITs). I believe a systematic end to the Fed's asset purchase program will also portend well for mREITs in the future. Furthermore, mREITs are effectively repositioning their investment portfolios to protect book values in case of an increase in interest rates and a volatile rate environment. I believe that in the current industry environment, ARMOUR Residential REIT (NYSE:ARR) remains a good investment choice for dividend investors, as the company offers a high dividend yield of 14.4%. Also, the company has taken the right steps to protect its book value by shortening asset duration and increasing hedge positions. In the future, rate sensitivity will reduce due to tightening of the duration gap. Therefore, I believe ARR is among the well-positioned mREITs in the industry.

Portfolio Repositioning
Interest rates are likely to increase and remain relatively volatile as the Fed is likely to end its asset purchases by the end of 2014. To protect its book value in case of an increase in interest rate volatility, ARR has been taking the right steps by repositioning its investment portfolio, primarily through the shortening of assets duration.

In 1H2014, the company entirely sold its 30-year fixed MBS, which previously comprised 40% of its investment portfolio, and now owns mainly 15-year and 20-year fixed rate agency MBS, which are now 70% and 30% of its investment portfolio, respectively. The repositioning of the investment portfolio and favoring of lower duration assets will help the company reduce its rate risk profile. Also, the company is replacing expiring long-term interest rate swaps with Eurodollar futures and short-term interest rate swaps. The hedging position of ARR will allow it to avoid greater initial margin requirements due to Dodd-Frank.

The repositioning of the investment portfolio and changes in the hedging position will allow the company to protect book value in the future. However, the hedging costs for the company are likely to increase by $0.017 per share in the coming quarters, due to the additions of swaps.

Financial Performance

The company reported a satisfactory financial performance for 2Q14. The company's book value increased by 5% quarter-over-quarter to $4.90 per share. The increase in ARR's book value for the quarter was driven by an unrealized gain in the fair value of ARR's agency Residential MBS due to the easing of the rate volatility environment in the bond market. The company's core EPS for the quarter came out to be $0.13, missing consensus estimates of $0.15 per share. Earnings for the quarter were adversely affected by the lower asset earnings yield and a higher-than-expected premium amortization expense. Net interest margin was 1.46%, as compared to 1.88% in 1Q14. The drop in net interest margin was due to a decrease in average asset yield, whereas the cost of funds remained relatively constant at 1.4%. The drop in asset yield was due to the spread tightening in the agency MBS market. The following table shows the performance matrix for ARR.

1Q14

2Q14

Book Value Per Share

$4.67

$4.90

Asset Earnings Yield

3.19%

2.72%

Core EPS

$0.15

$0.13

Click to enlarge

Source: Company Quarterly Report

Dividends and Share Repurchases
ARR offers a high dividend yield of 14.4%, which remains one of the most attractive dividend yields in the mREITs space. I believe dividends offered by the company are safe and sustainable. Also, the company's hedging and portfolio repositioning efforts will produce sufficient core earnings to cover dividends in the coming quarters.

Also, ARR's board authorized share repurchases of up to 50 million shares and $100 million earlier this year. However, the company did not utilize its share repurchase program in 2Q14. As the company's stock is trading at a discount to its book value (currently ARR is trading at a price-to-book value of 0.85x), ARR could become more active in share repurchase activity to take advantage of depressed valuations. The share repurchases will help the company fuel its EPS growth and magnify ROE.

Valuation
I believe the current valuation for ARR remains attractive compared to its peers. The stock is trading at a price-to-book value of 0.85x, compared to its peers' average of 0.92x, as shown in the table below. Also, ARR is currently trading at a discount to its historical price-to-book value of 1x.

ARR

Annaly Capital (NYSE:NLY)

Invesco Mortgage. (NYSE:IVR)

AG Mortgage Investment Trust, Inc. (NYSE:MITT)

MFA Financial (NYSE:MFA)

Dynex Capital (NYSE:DX)

Average

Price to Book Value

0.85x

0.90x

0.88x

0.97x

0.94x

0.95x

0.92x

Click to enlarge

Source: Yahoo Finance

Using the current book value of $4.90 and its peers' average price-to-book value of 0.92x, I have calculated a price target of $4.50 for ARR. The stock offers an upside price potential of 7% and a total potential return of 21.3%, including a dividend yield of 14.4%. The table below shows the price target calculation for ARR.

Current Book Value

Peers Average Price to Book Value

Price Target

$4.90

0.92x

$4.50

Click to enlarge

Conclusion
I believe ARR remains a good investment for dividend investors, as the stock offers a high dividend yield of 14.4%. Also, the company has been taking the right steps by repositioning its investment portfolio and adjusting hedge positions to protect its book value in case of an interest rate increase or if the interest rate environment becomes more volatile. Moreover, the company has an option to undertake share repurchases, which will portend well for its EPS growth. Furthermore, the current valuation for ARR remains attractive and the stock offers a potential price appreciation of 7%. Due to the aforementioned factors, I am bullish on ARR.

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.