American Capital Agency 25% Undervalued, Cheap In Service Sector

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Includes: AGNC, S, T, VZ, WIN
by: Takeover Analyst

What follows is a list of companies specializing in the service sector with varying degrees of upside. They cover a variety of core industries: mortgage REITs, cell phone carriers, and communications providers (the last two have meaningful overlap, however.) I find that the telecom companies mentioned in this article will underperform American Capital Agency (NASDAQ:AGNC). Financials are still heavily discounted - especially where anything real estate is concerned - due to irrational perception of risk. As the economy picks up, risk discounting will dissipate and cause, in my view, financials to outperform telecom.

The reason I have chosen to contrast a financial company to two telecom players (one that is a cell phone carrier; the other, a communications provider) is to illustrate how returns can be unique within a given sector. Due to its strong correlation with consumer expenditure, the service sector will likely outperform other sectors. However, within the sector itself, there are a diversity of industries. In my view, financial companies are more capable of leveraging off of the full recovery inflection point than telecom companies.

American Capital Agency

American Capital Agency trades at a respective 5.8x and 6.2x past and forward earnings while offering a 16.6% dividend yield. Consensus estimates for the company's EPS forecast that it will decline by 4.6% to $4.79 in 2012, grow by 0.2% in 2013, and then fall by 3.8% in 2014. Assuming a multiple of 8x and a conservative 2013 EPS of $4.70, the stock would hit $37.60 - soaring by 25%.

After the housing crash and financial crisis, many investors are on panic mode about mortgage REITs. According to the Street, however, investors should put their faith into American Capital Agency. The company is still 60% less volatile than the broader market and will fare well in the low interest rate and improving credit environment.

Verizon (VZ)

Verizon trades at a respective 43.8x and 13.5x past and forward earnings with a divined yield of 5.4%. Consensus estimates for the company's EPS forecast that it will grow by 14.9% to $2.47 in 2012 and then by 12.6% and 10.4% more in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $2.71, the stock is fairly valued.

As the industry consolidates, I anticipate that Sprint (NYSE:S) will continue to bleed cash and consider declaring bankruptcy. At the same time, I expect AT&T (NYSE:T) to grow through consolidation and possibly take market share away from Verizon. While Verizon does not have nearly as much risk as Sprint, it is under attack by AT&T. This is a good thing for investors, since I think the risk is far outweighed by the reward. Investors should consider backing companies like Verizon where the base has been set low.

Windstream (WIN)

Windstream trades at a respective 33.9x and 15.6x past and forward earnings with a dividend yield of 8.9%. Consensus estimates for Windstream's EPS forecast that it will decline by 25% to $0.57 in 2012, grow by 26.3% in 2013, and then fall by 12.5% in 2014. Assuming a multiple of 15x and a conservative 2013 EPS of $0.68, the stock would fall by 8.9%.

Windstream is 20% less volatile than the broader market and has a strong enough brand to grow market share when there is a full recovery. While I would not invest in the company now, I believe that, when the multiples depress in a few years, the stock will be a potential outperformer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.