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American Capital Agency Corp. (AGNC) is a Nasdaq-listed mortgage real estate investment trust ("mREIT") with a market capitalization of ~$10.2 billion and assets on the balance sheet as of 3/31/12 totaling ~$88 billion. AGNC owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations, callable debentures and other securities backed by pools of mortgage loans.

Total returns generated from the date indicated through 7/5/12 (based on the $34.02 closing price) are summarized in the table below (note that the percent total return is the return for the entire period, not per annum):

From

Share Price Change thru 7/5/12

Dividends thru 7/5/12

Total Return

Approx. Total Return %

12/31/2008

$12.42

$17.60

$30.02

27%

12/31/2009

$7.48

$12.45

$19.93

22%

12/31/2010

$5.28

$6.85

$12.13

21%

12/31/2011

$5.94

$1.25

$7.19

42%

Table 1

Past returns appear to be attractive, even more so than those generated by Annaly Capital Management, Inc. (NLY), another large mREIT I reported on in an article dated June 18, 2012. The current yield is also enticing at 14.7%. However, investors familiar with my approach know the first question I ask is what portion, if any, of the dividends I am receiving are really "earned". I am leery of investing in entities (publicly traded partnerships or companies) that pay dividends, or fund distributions, by issuing debt or additional equity. In taking a closer look at AGNC I encountered difficulties similar to those I faced when reviewing the performance of master limited partnerships ("MLPs"). Since money is fungible and the AGNC annual report runs over 100 pages that are frequently hard to understand, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.

Several examples can illustrate the complexities. The bulk of AGNC's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or Ginnie Mae, and of corporate debt (together, "Agency Securities"). These are classified for accounting purposes as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. Another example is discontinuing hedge accounting for its interest rate swaps beginning in 4Q 2012. This will reduce the balance of net losses accumulated on the balance sheet (under "Accumulated Other Comprehensive Income") with respect to such interest rate swaps and increase the interest expenses over the remaining contractual terms of these swaps.

Using the same definition of distributable cash flow ("DCF") I applied to the analysis of NLY, I create a quantitative standard that I view as an indicator of AGNC's ability to generate cash flow at a level that can sustain or support an increase in quarterly distribution rates. The definition is relatively simple: net income + amortization (a non-cash item), + losses (or minus gains) on assets & liabilities (also non-cash items), less cash used for working capital.

The results for the past 3 years are outlined in Table 2 below:

12 months ending:

12/31/11

12/31/10

12/31/09

 

Net income

770

288

119

 

Amortization

361

105

36

 

Losses (gains) on assets & liabilities

(26)

(130)

(46)

 

Cash used for working capital

(89)

(30)

(16)

 

DCF

1,016

233

93

 

Dividends paid

(664)

(173)

(80)

 

DCF excess over dividends paid

352

60

13

 

DCF coverage of dividends

1.53

1.34

1.16

 

Table 2: Figures in $ Millions except coverage ratios

The results for 1Q 2012 and 1Q 2011 are outlined in Table 3 below:

3 months ending:

3/31/12

3/31/11

Net income

641

134

Amortization

152

48

Losses (gains) on assets & liabilities

(263)

(16)

Cash used for working capital

(58)

(38)

DCF

472

128

Dividends paid

(314)

(91)

DCF excess over dividends paid

158

37

DCF coverage of dividends

1.50

1.41

Table 3: Figures in $ Millions except coverage ratios

Amortization charges reflect the purchase of Agency Securities at a premium (so valued because their stated coupon exceeds market rates). The premium is paid with the expectation that the higher than market coupon will be paid over the expected life of the security. If the expectation turns out to be wrong and the actual life is shortened due to more rapid than anticipated repayment of principal, DCF will suffer. Amortization for an mREIT is therefore a far less predictable and stable component of DCF than an MLP's depreciation charge.

The key drivers of the sharp increases in net income can readily be seen:

Period:

3 months 3/31/12

12 months 12/31/11

12 months 12/31/10

12 months 2/31/09

Total assets end of period

88,417

57,972

14,476

4,626

Total equity end of period

8,718

6,212

1,572

547

Leverage at end of period

10.14

9.33

9.21

8.46

Interest rate spread for period

2.31%

2.30%

2.33%

2.93%

Table 4: Figures in $ Millions, except leverage and spreads

As part of my analysis, I also created a simplified cash flow statement designed to shed light on the sustainability of the dividends by, for example, grouping together and netting out numerous line items that deal with gains and losses that are reported in the income statement but are non-cash items (and therefore reversed out in the cash flow statement). I also separate cash generation from cash consumption and group together and net out numerous line items that deal with cash outflows for assets (e.g., acquiring assets outright or receiving assets as collateral and lending against them) and cash generated by assets (e.g., selling assets outright or giving assets as collateral and borrowing against them). This reduces AGNC's cash flow statement to just a few lines.

Results for the past 3 years are outlined in Table 5 below:

Simplified Cash Flow Statement:

12 months ending:

12/31/11

12/31/10

12/31/09

DCF excess over dividends paid

352

60

13

Non-repo debt issued (repaid)

(19)

73

-

Shares issued

4,377

1,055

222

Other cash generated, net

0

0

0

 

4,710

1,187

235

    

Payments for assets, net

(3,257)

(1,160)

(87)

(Decrease) in restricted cash

(260)

(56)

(1)

 

(3,517)

(1,217)

(88)

    

Net increase in cash & cash equivalents

1,194

(30)

147

Table 5: Figures in $ Millions

In these simplified cash flow statements proceeds from, and payments for, assets contain numerous types of netted items, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; d) principal payments on, or maturities of, securities owned; e) equity investments (including investments in affiliates). Of course, the net increase (decrease) in cash and cash equivalents ties to the company's financial statements.

Results for 1Q 2012 and 1Q 2011 are outlined in Table 6 below:

3 months ending:

3/31/12

3/31/11

DCF excess over dividends paid

158

37

Non-repo debt issued (repaid)

(4)

(5)

Shares issued

2,205

1,753

 

2,359

1,785

   

Payments for assets, net

(1,985)

(1,658)

Increase in restricted cash

21

1

 

(1,964)

(1,657)

   

Net increase in cash & cash equiv.

395

128

Table 6: Figures in $ Millions

Roughly speaking, on a net basis over the 3-year period of 2009-2011, AGNC generated ~$1.3 billion, raised a further $5.7 billion by issuing equity and non-repo debt (of which only $~54 million was from such debt) and used the total of ~$7.0 billion to increase its portfolio ($4.5 billion), to pay dividends ($0.9 billion) and to increase its cash and restricted cash balances ($1.6 billion). Over this period, AGNC has demonstrated an ability to generate cash sufficient to both fund dividends and supplement funds raised via issuance of equity and debt in order to increase the size of the investment portfolio.

Clearly a 14.7% yield does not come without risks and past performance may not be a good indicator of future performance. All mREITs, including AGNC, have benefited from the accommodative stance of the Federal Reserve Bank which, for the past several years, has resulted in a relatively steep yield curve, albeit at low absolute rates. The shape of yield curve and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of return for AGNC which relies primarily on short-term borrowings to acquire Agency Securities with long-term maturities. Accordingly, profitability may be adversely affected if short-term interest rates increase. They could, as noted, also be adversely affected if mortgage rates decrease since this is likely to result in more rapid prepayments. In fact, in its 2011 annual report AGNC estimated that a 1% increase in rates is likely to cause far less damage (3.1% drop in projected net interest income) than a 1% decrease in interest rates (13.2% drop in projected net interest income). AGNC's Form 10-K lists numerous other risks.

As can be seen in Table 1, share price appreciation has accounted for a significant portion of total returns. Looking ahead, if management's measurement of net interest margin is correct, the current level of interest margin (2.31%) and leverage (10.14) indicate a return on equity of about 23%. The rate of return is higher than NLY's, but so is the leverage ratio. I am not sure which is more attractive on a risk-adjusted basis and will attempt to compare them in a future article.

Investors should perform their own due diligence and assess their individual tolerance for risk before buying or selling the shares.

Disclosure: I am long NLY.

Source: A Closer Look At American Capital Agency's Cash Flows