Understanding American Capital Mortgage's New Offering

| About: MTGE Investment (MTGE)

The Math

Now that we know American Capital Mortgage Investment Corp. (NASDAQ:MTGE) is selling its newest-issued shares at $23, we can calculate what this means for shareholders. Prior articles at Seeking Alpha described American Capital Mortgage's management as increasing net asset value per share ("NAV") by 91¢ over the last quarter of 2011 and by 91¢ over the first quarter of 2012. One might suppose, therefore, that American Capital Mortgage's NAV at the end of May -- 61 days into the second quarter -- might be about 61¢ higher than the $21.78 backing each share at the end of the first quarter, putting end-of-May NAV at about $22.39.

But, no.

American Capital Mortgage's value to shareholders isn't confined to NAV increase. Since it avoids entity-level taxation by qualifying as a Real Estate Investment Trust ("REIT"), the company is obliged to pay at least 90% of its taxable income to shareholders as dividends. The dividend has grown from 20¢ per share in the partial-quarter in which American Capital Mortgage first issued shares to investors in 3Q2011, through an 80¢ 4Q2011 dividend to its most recent dividend of 90¢ in the first quarter of 2012. The 90¢ dividend most recently paid amounts to about 1¢/day - the same scale as the NAV increase. Because the dividend for the second quarter has not yet been announced, much less gone ex-dividend, the NAV will include all the earnings accretion that we'd expect to be declared in dividends later in the quarter. If the dividends and other NAV accretion are the same this quarter as last, then NAV at the end of May would be about $23.

Thus, the most recent issuance is apparently very nearly exactly at NAV.

The Benefit

When the curtain closed on 1Q2012, American Capital Mortgage Investment Corp. held enough undistributed taxable income ("UTI") -- the stuff that must be distributed (at least 90% of it) and taxed in connection with this tax year -- that each share had accumulated 53¢ of the overhanging obligation. This, despite opening 1Q2012 with only 24¢ per share and more than doubling the share count during the quarter. Thus, even while increasing the share count the company's undistributed profit (and overhanging tax obligation) grows even faster.

New shareholders presumably want to receive the company's dividend and will be undisturbed to be paid the dividend. Old shareholders presumably want the dividend, too, but if they are rational optimizers they also want the best after-tax return they can get. When new shareholders chip in pure equity equal to the shares' NAV, the result is the increase in equity in each share and the reduction in each share of the overhanging obligation to distribute taxable income this year. In other words, the substitution of equity for UTI effects what is to the old shareholder a tax deferral mechanism. Technically, there's no tax deferral; American Capital Mortgage must still pay 90% of its taxable income -- it's just that since UTI previously hanging over the heads of old shareholders is shifted across more shares following issuance so that the new shareholders pay the taxes on carried-forward profits distributed to them instead of to old shareholders. Since the distribution of taxable income is replaced with an untaxed increase in NAV, the effect of the substitution to old shareholders is deferral.

Let's have a look at the tax benefit in the transaction at this newest issuance price of $23. The undistributed taxable income in each share just prior to the end-of-May transaction close will be the 53¢ from the end of 1Q2012, plus the accumulated additional taxable income since the close of the quarter. The taxable income in 4Q2011 was $1.07 per share and the taxable income in 1Q2012 was $1.56. However, understanding the steady state earnings of a company with less than a year of history is beyond the scope of this paper. Suffice it to say that since net spread income in 4Q2011 was $0.86 and in 1Q2012 was $1.07, the effect of realized gains on taxable income has been something like 21¢ in 4Q2011 and 49¢ in 1Q2012. Since the share count more than doubled in 1Q2012, this article will make a conservative assumption that realized gains are more like those in 4Q2011 because so much of the capital per share (and related hedges) consist of new investment and unready to produce realized gains. So to UTI carryforward of $0.53 we add about $0.73 in new taxable income per share, for UTI entering the transaction of $1.26. Based on the estimated $23 transaction-date NAV and the $23 offering price, more than eleven million new shares will add approximately 50% to the share count while having no material effect on NAV. However, UTI per share will be reduced to 84¢, reducing the obligation to pay taxes on 42¢ of income otherwise taxable to prior shareholders.


The benefit to prior shareholders is best measured by multiplying their marginal tax rate by the approximately 42¢ per share in taxable income shifted to other shareholders. A corporation paying a 35% rate would enjoy a reduction in taxes of about $0.15 per share as a result of the transaction. This tax benefit will not be useful to persons holding shares in a Roth IRA (in which reinvestment goes untaxed and from which retirement withdrawals are tax-free), but is extremely valuable to investors holding the shares in a conventional account. It represents a rare way a conventional account can experience something like tax-deferred reinvestment of earnings into a double-digit-dividend stock. The effect is limited to 15¢ of the income coming investors' way this quarter, but it's not the first time the company's external manager American Capital Ltd. (NASDAQ:ACAS) has pulled a trick like that this year, and it won't be the last. Considering that 15¢ is very nearly half of the after-tax income kept by a 35% taxpayer following a 90¢ quarterly dividend, the tax-deferred 15¢ is a significant boost to after-tax gains.

The large size of American Capital Agency (NASDAQ:AGNC) makes unlikely so extreme a tax-deferral effect in a single issuance, but it also enjoys the same "deferral" principle at work for shareholders on issuance. It's nice to enjoy equity accretion at issuance, but American Capital's hidden deferral effect is good to investors even without it.

Disclosure: I am long ACAS, AGNC, MTGE.

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