American Capital Mortgage: Likely Better Than Its Dividend

| About: MTGE Investment (MTGE)

American Capital Mortgage Corp. (MTGE) is a sister company to American Capital Agency Corp. (AGNC), about which I wrote on Seeking Alpha long before AGNC's dividend reached $1.40 per quarter or its trading price approached $29. Both companies are employee-free and share the same management team supplied for a management fee by American Capital Ltd. (ACAS). Each is a REIT that owns no real estate, but invests in interests in real estate -- in this case, the security interests in the real estate that provide the first level of protection to the mortgage bundles from which their portfolios are built.

ACAS' record for managing mortgage-REITS ("mREITS") should be considered when assessing the apparent return of MTGE on the basis of its upcoming $0.80 per share quarterly dividend. This dividend will be the first paid by MTGE following a full quarter of operations; the $0.20 stub quarter dividend was based on a 54-day period in which its portfolio's average leverage was 4.7x and its net interest spread in the quarter was 2.13%. The $0.80 dividend was declared following a quarter that began with a net interest spread of 2.41% and a leverage of 7.8x. We haven't seen the quarterly results for the fourth quarter of 2011 yet, but a look at the history of ACAS' management of AGNC and the performance in the stub quarter suggest that MTGE's dividend tells a lot less about MTGE's financial performance than the quarterly results will.

When AGNC announced its first stub quarter dividend of $0.31, indiscriminate observers concluded that AGNC's annual yield was 1.6%. I looked at the $14 stock, saw a dividend that seemed to promise at over $0.90 per quarter, and caved in and bought. With more careful math, I suggested here at Seeking Alpha that annual earnings at AGNC might be on the order of $5 and that annual dividends seemed susceptible to high be rather higher than the single-digit rates suggested elsewhere. Despite launching AGNC in the first half of 2008 - on the eve of the financial meltdown - ACAS has raised AGNC's NAV to $26.90 and led it to a quarterly dividend of $1.40. Part of the secret to AGNC's success during that time was conservative hedging activities; there was a point in late 2008 when ACAS made so much money from its hedges (insurance against the factors that impacted the value of the portfolio) that there was concern it might not make enough of its profit from real estate to qualify as a REIT.

With similarly somnolent analysis as with AGNC, indiscriminate observers proclaimed MTGE's annual yield to be 4.5% after the $0.20 stub dividend. Here, comparisons favor MTGE. When AGNC paid $0.31 after its first quarter, the news shortly followed that AGNC had earned $0.37, and had kept 6 cents to add to its deployed capital and to raise its future dividends. And raise them it did: after I predicted a full-quarter dividend exceeding $0.90, AGNC announced that its first full-quarter dividend would be $1.00.

And what's afoot with MTGE? In MTGE's inaugural partial-quarter, it reported "earnings" of $0.25. Due to FAS 175, "earnings" includes changes in value of many investments that prior to FAS 157 would not result in "earnings" until a the realization of a gain or loss on disposition. MTGE's $0.20 stub-quarter dividend constituted only 80% of the stub-quarter "earnings" - for a 25% earnings reinvestment that surely was major contributing factor to the NAV at the start of the fourth quarter being $19.96, much closer to the $20 IPO price than MTGE would have realized after IPO-related expenses, discounts, and fees. Leveraging this raised NAV at 7.8x with a net investment spread of 2.41% (the numbers at the start of 4Q2011), one would estimate quarterly earnings north of $0.90. If accurate, MTGE is reinvesting more than a dime per quarter - over 10% of its quarterly earnings after payment of a dividend of $0.80 - a reinvestment leading straight back into the capital deployed to make money for shareholders, and raising MTGE's NAV. If accurate, MTGE's NAV is now north of $20. As AGNC's trading price has equalled or exceeded its NAV for some time now, it's possible that as MTGE demonstrates characteristics similar to AGNC, a short-term opportunity exists for share price movement independently of NAV-driven price gains. For the DRIP investor, this is not to be hoped for; but NAV-discount evaporation has led to gains for those who picked up shares when, before the $0.80 dividend was declared, shares languished south of $17.

Ignoring the effect of hedges (about which I have too little information to make estimates), it seems ACAS' management team is in a position to make something rather north of $3.50 per year with MTGE's portfolio, which must due to MTGE's tax status be mostly passed to investors in the form of dividends. At prices approaching $19, MTGE offers an apparent return of something on the order of 19%. Some of that might come from dividends, but a not inconsiderable amount seems set to come from NAV increases. Given that MTGE's dividend obligation is based on taxable profit, rather than SEC-reported "earnings," some variation should be expected between "earnings" and the dividend based on realized profits. Since ACAS' management fee is based on assets under management, it has a rather strong incentive to reinvest whatever it is permitted to reinvest.

At present, ACAS is a substantial shareholder in MTGE. However, experience with AGNC was that ACAS sold its stake over time. Perhaps now that ACAS is in a financially superior position to the besieged state in which ACAS found itself after 2008, it will be inclined to remain a long-term investor in MTGE. After all, if ACAS hadn't been under liquidity pressure a few years ago it sure would have done better to have kept the AGNC: now north of $28 and paying a dividend close to 20%, it's treated its owners pretty well.

Disclosure: I am long ACAS, AGNC, MTGE.