Arlington Asset Investment (AI) is a small-cap mortgage REIT with an unmatched dividend yield of 14.3%. The company demonstrated tremendous growth when it reported its second-quarter performance for the current year. Going forward, Arlington will benefit from the third round of quantitative easing (QE3). As noted below, the book value of the company's holdings will surge as a result of QE3. The stock trades at cheap valuations when compared to most of its peers, which makes us bullish on AI.
Arlington Asset Investment is a micro-cap U.S. mortgage REIT with a market capitalization of $242 million. The company seeks to invest largely in residential mortgage-backed securities, for which the interest and principal payments are guaranteed by the government or any of its sponsored agencies. Since 2009, the company also started investing more in private label mortgage-backed securities (issued by private organizations) to enhance returns. All of the Agency MBSs are fixed rate in nature with prepayment protection, while private label MBSs were composed of both fixed and adjustable rate securities.
Asset Portfolio Composition
The fair value of the company's mortgage-backed securities was $1.2 billion, with an average coupon of 4.5%. Around 85% of the asset portfolio is composed of Agency-backed fixed rate mortgage-backed securities, while the remaining are private label. The proportion of Agency securities to the entire MSB portfolio has increased from 78% at the end of the quarter ended Dec. 31, 2011. The total assets portfolio swelled from $816 million at the end of the fourth quarter of the previous year to $1.19 billion at the end of the second quarter of the current year.
Recent Quarter's Performance Review
The turnover that the company generated during the second quarter of the current year surpassed its consensus estimate by 1%, while the bottom line remained 3.7% behind analyst expectations. There was an overall improvement in the results of operations for the second quarter, as compared to the first quarter of the current year.
- The interest income of $16 million for the second quarter was 21% above the $13.2 million net interest income of the first quarter of the current year. The yield that the company earned on its interest yielding assets dropped by 67bps to 6.05% at the end of the second quarter of the current year. This is compared to 6.72% at the end of the same quarter of the previous year. Private label MBSs remained the highest-yielding assets during the second quarter, with over 17% asset yield.
- Interest expense of $1.1 million, which includes the cost of funds, surged by 89% over the linked quarter. The company paid 0.44% on its repurchase agreements for the second quarter. This is against 0.31% in the same quarter of the prior year.
- Net interest income of $14.9 million, which is the interest the company earns over the cost of funds, surged by 17.3% when compared sequentially. Compared to the prior year's 6.41%, the net interest spread for the second quarter declined to 5.61%. This reflects the effect of the flattening of the interest rate yield curve.
- The second-quarter bottom line surged significantly from $91,000 at the end of the first quarter to $2.14 million.
- The company is moderately leveraged as compared to most of its peers. It has a leverage ratio of 4.4 times at the end of the second quarter of the current year. AG Mortgage Investment Trust (MITT) and Dynex Capital (DX), the other two small-cap mortgage REITs, have leverage ratios of 6.2 times and 5.9 times, respectively. MITT and DX have market caps of $500 million and $586 million, respectively. American Capital Agency (AGNC) and Annaly Capital Management (NLY), the large-cap U.S. mortgage REITs, have leverage ratios of 6 times and 7.85 times, respectively.
The stock offers an unmatched dividend yield of 14.3%. However, our analysis suggests that dividend distributions are not well backed by the cash flows it generates from its operations. The company paid $24 million in dividends during the past year, while it generated $27.3 million in cash from operations. However, on a quarterly basis, the company generated $6.77 million on average during the past four quarters, while it paid $7.2 million in quarterly dividends on average over the same time. This is a shortage of $0.43 million, or 4.4 cents per share. The company offers 87.5 cents per share in quarterly dividends. Adjusting for the shortfall, investors can expect future quarterly dividends of 83 cents per share. If the company cuts dividends, the new dividend yield comes out to be 13.2%, still sufficiently higher than most of its peers in the mortgage REITs industry.
Looking at last quarter's operating cash flows and dividends paid figures alone, the shortage comes out to be $0.68 million, or 7 cents. The new dividend yield, after adjusting for the last quarter's cash shortage, comes out to be 12.8%. This is the dividend distribution that an investor can expect if the situation doesn't improve. Looking at the consensus earnings estimates for the coming (third) quarter of the current year, we believe the company will be able to continue its original dividend distribution of 87.5 cents per share. Analysts have a consensus mean earnings estimate of $1.11 per share, while the low estimate is 97 cents per share, sufficiently covering the dividend distribution.
Arlington has attractive valuations when compared to its peers in the micro-cap mortgage REITs industry. The stock of Arlington Asset Investment trades at a 9% premium to its book value, as compared to 21% and 12% premiums for PennyMac Mortgage Investment Trust (PMT) and Dynex Capital, respectively. Analysts have a mean price target of $27 for Arlington. This is an upside of 8% over the current share price of $24.98.
The announcement of the much-anticipated third round of quantitative easing will have multiple affects on Arlington's stock price. Where the book value of Arlington's current holdings is expected to surge, the prepayments will also accelerate. However, most of the company's fixed rate Agency backed mortgage-backed securities are prepayment protected. Under QE3, the Fed aims to purchase $40 billion worth of mortgage-backed securities, which will result in a downward pressure on the MBS yields and an upward pressure on the MSB prices, resulting in an increase in the value of AI's holdings.