It has been a few months since I last covered Armour Residential REIT (NYSE:ARR). As many of you know I have followed ARMOUR Residential REIT and have been extremely sour on the name for some time. I have urged investors against jumping in despite the massive discount-to-book for over a year. Earlier this morning I was contacted again about the name for a fresh perspective. Now I have to say, in this sector, things do change rapidly. What was once strong can quickly turn sour, but was once weak, can also emerge as a strong name. I think ARMOUR has started to turn the corner. All I ask in a name is for dividend coverage without massive book value erosion. Much of this can be beyond the company's control (e.g. prepayments, interest rate movements) but the company can try to position itself appropriately given known and predicted circumstances. Now, that said, the company has just released Q4 earnings and I want to discuss the critical key metrics you should be looking for.
The first thing I want to say is that this is now the second rather strong quarter relative to the sector as a whole in a row. This follows almost two years of lagging the market, but as I said, it can change quickly. I have wanted you to avoid the name as I felt you were just going to lose (on paper) your principle. I have wanted you to wait for a turn-around before choosing to do some buying? Is that time here?
Well the stock definitely looks like it has potential to be a buy at this point. First, core income, a great measure for determining income available to pay dividends, came in at $47.7 million, which was $1.10 per share. This was however down quarter-over-quarter from the $52.4 million, or $1.11 per share in Q3. The reason for the per share earnings being nearly flat was due to the company's buyback. While not a measure that is as important for mREITs as core income, the company actually swung to a GAAP net income of $117.8 million (or $2.88 per share) compared to a loss of $221 million or $5.18 per share last quarter. The key here is that the company's core (plus drop) income was far more than enough to cover the dividends. Remember, the company paid dividends of $0.99 per common share of record for Q4 2015, resulting in payments of approximately $39.5 million. The company also paid monthly dividends in Q3 2015 of $0.171875 per outstanding share of 8.250% Series A Cumulative Redeemable Preferred Stock and $0.1640625 per outstanding share of 7.875% Series B Cumulative Redeemable Preferred Stock, resulting in payments to preferred stockholders of an aggregate of approximately $3.9 million.
The issue to remember is that ARMOUR had been having issues covering its dividends, resulting in multiple cuts. It even failed to cover the payout in early 2015. However, this is the second quarter in a row the company out-earned its payout. Recall that dividends in excess of taxable REIT income for the year will generally be treated as non-taxable return of capital to common shareholders. It was forced to go this route in past quarters, but now it is covering it. In three quarters it went from failure to cover the dividend, to barely covering dividends, to covering dividends, resulting in so-called "spill-over." I am pleasantly surprised with these results but I want you to understand what is driving them.
This is where things get interesting. As most of you know by now, one of the key metrics I always look for in mREITs is the net interest rate spread because it is a proxy for the earnings power of the portfolio. In the fourth quarter, the annualized yield on average assets jumped to 2.71% up from 2.56% in Q3. Further the annualized cost of funds, was 1.13%, essentially flat from Q3. The end result? The net interest spread widened to 1.58% from 1.44% This is still quite low in the mREIT sector, although it's higher than some competitors in the space. But the key is that it is widening. Of course there is always the all-important book value. This metric was way down again. ARR reported its so-called shareholder equity to be $3.96 at the end of Q2; adjusting for the reverse split this was $31.69. It fell in Q3 to just $29.05. It was down again another 3.5% to $28.00 in Q4. While the stock trades at 31% discount-to-book, I am still cautious. I say this because book value continues to erode, and I see no signs of the bleeding stopping.
So what is the deal? All past coverage aside, the company showed significant improvement. The company is turning the corner but I must caution that the sector could see some continued prepayment pressure moving forward because there has been an uptick in refinancing of late. At this point I will continued to bless some cherry-picking buys in the name, but the falling book value is concerning. I commend ARMOUR for a second strong quarter. The question is whether or not this momentum can be sustained. Still, that 21% yield based on the $0.33 dividend monthly is enticing. If you have no concern for the principle on paper and are looking for income, this name could be a top pick. But I think you need to protect principle as much as you can, and so I highly recommend it be one piece of a well-diversified portfolio should you choose to go long the name.
Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles, which are time sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.