Arlington Asset Investment (NYSE:AI) is a small corporation operating in an environment that is largely dominated by mortgage REITs. The company is facing off against the Clinton Group and Imation (NYSE:IMN) in a proxy battle. There are several factors for shareholders to know before they vote, but some should be heavily emphasized. My opinion on the proxy battle is that shareholders should be voting the white card. This card supports management, and it is my opinion that the current management team has the best strategy by a huge margin.
The Clinton Group previously launched a successful proxy war to take control of Imation. Due to the overlap between the Clinton Group and Imation, I may refer to activities taken by IMN as activities of the Clinton Group at times and may refer to either with the term "activist". Despite the use of the term "activist", you'll see that I find the term to be poorly applied here.
There will be quite a few forms referenced in this article. To make matters easier, each form will be linked the first time it is mentioned. Because the forms may often have the same names I will include the filing dates for most forms. An investor can find all the forms by viewing the SEC listing.
Over the last couple weeks, I've been digging into Arlington Asset Investment frequently. The company trades at a substantial discount to book value. Even compared to peers, the discount for AI is substantially larger. I've called AI and requested an interview with the management, but do not have an answer yet.
Management most recently established its point of view in a proxy filing on April 26th, 2016:
While I believe there is substance to the defense offered by AI, there is also a burden on the activist to prove that a problem exists and that they hold the solution. It is my opinion that Imation and the Clinton Group failed to prove that case.
In a Nutshell
The proxy battle is being classified as "activism", but I wouldn't want to use that term. Activists are usually large shareholders that are tired of weak performance. The Clinton Group initiated its position very recently and immediately launched into a proxy war. The argument advanced by the Clinton Group suggests that management of AI has failed and that shareholders would be better off with a new board of directors. I strongly doubt these claims.
Clinton Group's Position
The Clinton Group's position in equity is a very small fraction of the total shares outstanding. It is dramatically less than 1%. There were nearly 23 million shares outstanding and the activists own 11,000. This is a mere .048% of the stock. At recent share prices of $12.84, the total value of this investment would be $141,240.
According to the form PREC14A filed on 04/20/2016, Imation is bearing the substantial costs of the proxy battle:
"The entire expense of soliciting proxies is being borne by Imation. Costs of this proxy solicitation are currently estimated to be approximately $1,000,000. Imation estimates that through the date hereof, its expenses in connection with the Proxy Solicitation are approximately $50,000. If successful, we may seek reimbursement of these costs from the Company. In the event that we decide to seek reimbursement of our expenses, we do not intend to submit the matter to a vote of the Company's shareholders. The Board would be required to evaluate the requested reimbursement consistent with their fiduciary duties to the Company and its shareholders. Costs related to the solicitation of proxies include expenditures for attorneys, advisors, printing, advertising, postage and related expenses and fees."
In a nutshell, this form is indicating that Imation is ready to spend $1 million in activism costs for a position where the common shares were worth less than $150,000. For the activist to earn their money back (starting from a default share price of $12.84) through share price appreciation and dividends, it would require a return of around 700%. That should be enough to make investors look very skeptically at the "activism". On the other hand, it would be possible for a much smaller return to be sufficient if the battle is won and new directors of Arlington Asset Investment decide to reimburse those costs.
Imation retained Okapi Partners LLC ("Okapi") to assist in this proxy battle. According to the previously linked filing, it is expected that Okapi will employ approximately 25 individuals to solicit shareholders in favor of the activist. In exchange for this help, Okapi is to receive a fee "not to exceed $300,000, together with reimbursement for its reasonable out-of-pocket expenses…"
The 11,000 shares acquired by the activists pale in comparison to the 667,000 shares owned by the current board of directors. If shareholders are going to be influenced by the alignment of interests, it speaks volumes that the current board owns about 60 times as many shares as the activists.
The Argument Against Management
The Clinton Group argues that returns to common shareholders, even after adjusting for dividends, were weak for the last five-year period. Specifically the period goes from the end of Q1 of 2011 to the end of Q1 of 2016. It is absolutely critical that the time period is carefully selected because the returns depend heavily on the starting share price. In early 2011, there was some very substantial volatility in the share price.
No Cherry Picking
Using Yahoo's values for dividend adjusted close, the total return from the end of 2011 Q1 to the end of 2016 Q1 would be about a negative 19.8%. That looks downright terrible. However, if investors use the returns since the end of Q4 of 2010, three months prior, the total return would be 5.7%. While 5.75% still sounds weak, Annaly Capital Management (NYSE:NLY) provided a total return of 8.85% during the same period. The weakness also disguises that AI is still trading at a substantially larger discount to trailing book value than peers. If the company were trading at similar discounts to peers, it would have dramatically outperformed Annaly Capital Management during that 5.25-year period.
If Returns Weren't Bad and the Position Isn't Large
Shareholders in Arlington Asset Investment really need to ask themselves why an activist would risk a million dollars on a campaign when they own a small percentage of the shares. They may also want to ask why the measurement period was so carefully picked.
I believe the answer lies in the latest form filed by the activists: Form PRRN14A filed on 04/27/2016.
The following lines from that paragraph tell shareholders a great deal:
"We believe that our Nominees, in conjunction with the Company's continuing directors, can work hand in hand to improve the Company's financial position by undertaking initiatives to solicit the best external manager through a request for proposal process, restructure bonus compensation for executives to be earned upon tangible book value creation and be heavily weighted toward stock compensation in order to create stronger incentives for executives to generate value for shareholders and for the Company, reduce the Company's overall fixed cost structure, recalibrate hedging strategies, and diversify the Company's portfolio using strategies that create more attractive yields and that develop value by investing in new businesses."
I don't believe an external management agreement would be viewed favorably. External management agreements usually assign compensation as a function of equity rather than paying for performance. Those contracts also usually contain large termination penalties, and I believe those penalties are one of the reasons mREITs upon liquidation have regularly been offering only 80% to 90% of book value to shareholders.
If the activist wins and an external manager is selected, I would be very surprised if it was a group that had absolutely zero connection to the activists. The argument for risking $1 million on a proxy war while owning less than .05% of the common shares only makes sense if there is a method through which equity or cash can be extracted from AI.
The suggestion by the company also indicates intent to "develop value by investing in new businesses". Since Imation invested capital in funds affiliated with the Clinton Group, this could be a sign that some of the portfolio could be invested with the Clinton Group. This would create another method for extracting value from AI and transferring it to the activist.
Hedging Strategies and Yields
One of the other critiques was on the asset yields and hedging strategies employed by AI. The portfolio chosen by AI is not particularly unusual. The heaviest allocation is the 30-year fixed-rate agency RMBS with a coupon rate of 4.0. This is a fairly normal choice for mREITs. The hedge portfolio also falls within the range of typical hedging techniques for an mREIT. While AI is technically a corporation, the best comparisons continue to be mREITs. Whether "more attractive yields" mean higher yields or less volatile yields is not indicated, but I have no reason to believe that an overhaul of the portfolio would improve total economic returns to shareholders.
Referring back to the form PREC14A that was linked previously, the activists took aim at the executive compensation as being excessive. While the numbers may appear very high to many shareholders, they were in line with the compensation reported by internally-managed mREITs and lower than management fees paid by many externally-managed mREITs.
For comparison, I selected a few mREITs that also trade portfolios that are dominated by agency RMBS. These comparable firms are moderately larger in total equity, but their portfolios are also simpler. AI incorporates some non-agency RMBS, which increases the amount of work required.
Compensation and benefits in 2015 cost AI roughly $9.7 million according to the 10-K. CYS Investments (NYSE:CYS) spent roughly $12.1 million on compensation and benefits. Capstead Mortgage Corporation (NYSE:CMO) prides itself on exceptionally low expenses and spent about $10.2 million a combination of salaries, benefits, short-term incentives, and long-term incentives.
Arlington Asset Investment Corporation has been on my radar as an mREIT analyst due to a fairly large discount to book value. The largest weakness in its share price returns has not been a failure to manage the portfolio; it has been its company trading at a significantly larger discount to book value than peers. While there are some strategic questions I would like to ask management, there is no doubt in my mind that shareholders would be serving their own interest by voting the white card.
I do not own shares in AI, though they have been on my short list for potential investments. I receive nothing from AI in exchange for providing this coverage. I receive the standard payment from Seeking Alpha for publishing an article, but that doesn't explain the substantial time investment required to research this situation.
My reason for researching this is fairly simple. My readers need to know about this proxy battle. Shareholders need to understand the incentives. I've supported activists in other battles, but this would be a poor time for shareholders to vent their frustration by voting against management. If there will be 25 professionals employed to assist Imation, then I should at least provide shareholders with an opportunity to hear a viewpoint that was not purchased with a six-figure check.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PREFERRED SHARES OF ANY MREIT over 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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.