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Individual Investor and founder of Meridian Investments (a private investment club).
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  • AGNC: Sustainability Analysis For The Layman (KISS)

    I am writing this post in hopes of getting a few responses to my thoughts on other SA posts concerning AGNC's recent earnings. I am long (NASDAQ:AGNC) and (NASDAQ:MTGE) and admittedly not a financial professional, however, I do have a Finance degree and been following stocks since I was 8 years old.

    Very often I feel like "intelligent" investors over-complicate their analyses and "laymen" investors get lost in the details, fast forwarding to the author's point/recommendation at the end of the article. This is extremely dangerous as many of these analyses have GAPING HOLES in them.

    To me the value of any business should be determined solely by the cash flows provided to the investor over time, not the next 2-3 quarters. This is a simple concept, but seems to escape most new investors I talk to.

    The first article I'd like to discuss is Scott Kennedy's Dividend Sustainability Analysis...

    seekingalpha.com/article/1393001-america...-analysis

    This is a great article in terms of explaining how AGNC operates and why/how it pays its dividend. But as far as sustainability goes, there are two fundamental issues related to sustainability that are not addressed:

    1) The funding source of recent "Overpayments".

    2) The business model from a cash flow perspective.

    OVERPAYMENTS
    The first and most glaring issue I have with the article is using the company's history of overpaying as an indicator of the safety of the dividend. While this history may predict the likelihood of an "attempt" to repeat the practice through 2013, it has nothing to with
    the reality of it happening, or its sustainability long term. In fact, if anything this practice is UNSUSTAINABLE over the long term.

    Looking at his chart

    static.cdn-seekingalpha.com/uploads/2013....jpg

    he provides the following info:

    YEARINCOMEPAYOUT (%)OVERPAY $
    Over Payment Chart
    200842m96m (225%)54m
    2009114m230m (200%)116m
    2010247m887m (360%)640m
    20111,030m1,530 (150%)530m
    20122,100m??????

    Each quarter, they are paying out much more than the IRS requires (~230% vs. 90%). Most people compare each quarters dividend vs. that quarter earnings, but this is a mistake with REIT's. This quarter's earnings are driving NEXT YEAR'S payout requirements and should not be used to overpay this year's liability (NYSEMKT:IMO). Overpaying is just kicking the can down the road.

    I could make this really complicated and outline how they are achieving this through further capital raises, but in an effort to "Keep it Simple", my point is that their practice of overpayment REDUCES the sustainability of the dividend. If they were paying only what they owed, they would have a HUGE stash of cash in their UTI bucket (Undistributed Taxable Income) which would transparently show whether or not they would be able to pay next years dividend. Overpayments simply represent an early distribution of the current year's taxable income (technically it is not due until the following year). What I don't know is what happens if/when they cannot distribute 2013 profits because they are losing money
    in 2014?

    Which leads to my 2nd sustainability issue...

    BUSINESS MODEL & CASH FLOW...
    As mentioned, I have a finance background, but am not a financial professional. With that caveat, this is my understanding of their business (Someone please correct me if I am wrong)...

    BASICS...
    1) They raise 1B of capital.
    2) They are able to borrow 7-8x their capital in Short Term Notes.
    3) They borrow 8B at relatively low Short Term interest rates (say 2% and a 1 month duration).
    4) They use that 8B of cash to buy Long Term notes at higher rates (say 3.5% on 30 year mortgages).
    5) Each month they pay 2% interest on their ST debt and collect 3.5% on their LT investments.

    This 1.5% spread is "profit" so to speak. It does not sound like a lot, however, given that they are leveraged 8-1, this means they are getting 12% on the 1 billion of capital. The higher the spread, the higher the profits. 2% = 16%, 3% = 24%. The higher the leverage, also the higher the profits.

    ADDING COMPLEXITY I... SHORT TERM ROLLOVER RISK. (here's where it starts getting complicated)

    6) Each month, the company has to "rollover" its short term debt as it becomes due. So if ST interest rates go up to 2.1%, they have to borrow at 2.1% to pay off their 2.0% debt and their investment spread goes down to 1.4% (remember LT investments are yielding 3.5%). This ST vs LT interest rate risk is important to understand. In theory rates can go up .5% and they are fine from a cash flow perspective. They are still making a 3.5 vs 2.5 pct spread of 1 pct.

    The obvious disaster scenario is if short term rates spike 2% and their ST borrowing costs are 4% vs. an investment return of 3.5%. In this situation, they are losing money and losing it fast (remember they are leveraged). This is probably why their "risk" charts don't show rate increases larger than their spread. If that happens, the model is broken.

    ADDING COMPLEXITY II... MARK-TO-MARKET
    7) When interest rates move, so does the value of their investment portfolio. If ST rates go up, so do LT rates, which means there are
    better LT investments available to outside investors, so those investors are willing to pay less for AGNC's 3.5% assets.

    Personally, I don't care about this devaluation of assets as long as I am still getting my spread. Unfortunately though, the IRS does care and treats these changes in valuation as income. In absence of Overpayments, this would not be too big an issue, but...

    In a decreasing interest rate market (like the past 4-5 years), note valuations increase, creating taxable income and committing AGNC to dividend liabilities higher than their cash flow. This is not an issue though as they can simply sell their LT investments at higher prices to cover the additional liability.

    As interest rates increase, the opposite happens, but as mentioned, this portfolio fluctuation isn't that important IF they are still making spread and not overpaying dividend liabilities.

    BACK TO THE OVERPAYMENT PROBLEM
    Given that (AGNC) is spending this year's earned cash by overpaying last years dividend liability, lets look what REALLY happens when interest rates rise...

    1) Investment spread goes down... Cash Flow goes down.
    2) Now current year cash flow is less than previous year cash flow.
    3) IRS demands (AGNC) pay 90% of previous years cash flow as dividends.
    4) (AGNC) doesn't have enough cash flow to cover dividend liabilities, so they have to sell LT investments.
    5) LT investments are lower than they were purchased for, so these "paper" losses become "Realized" losses.
    6) Smaller Investment portfolio = Lower Cash Flow.
    7) Downward spiral continues until rates drop/stabilize.

    In a nutshell that is my concern... the Overpayments are creating an UNSUSTAINABLE situation and forcing distressed asset sales. Eventually rates WILL rise, cash flow WILL fall, and they WILL be forced to sell investments at a loss to cover dividend liabilities. If they had never made an overpayment, their UTI balance would always have enough to cover the current year's dividend liability and the dividend would be easily forecasted (similar to Oil Pipeline's contracting their rates and volumes well ahead of time).

    LOOKING FORWARD...
    In reality I think that when rates rise, instead of selling their LT investments, (AGNC) will just raise more capital to cover the dividend payments. BUT, remember they will have "paper" losses in an increasing interest rate environment. So even if they can cover current year's dividend payments (which they will by law), there will be no taxable income. And if there is no income, then no required dividends for the next year.

    Am I saying they won't pay dividends if they have paper losses for an entire year? No way. More than likely they will continue to have positive cash flow on the spread, but any new payout will be another Overpayment that will have to be addressed down the road. Also, they will likely continue to do capital raises to fund dividend liability, but what if the market tires of this model. Remember as LT rates increase, this vehicle becomes less appealing.

    One thing I may be missing is whether they can "Claim" previous overpayments against current year's liability. So if in 2013
    they make 3B in profits, but in 2014 they have only 2Bm of cash flow and 2B of paper losses, can they "claim" their 2008-2013
    overpayments to offset their 2014 dividend liabilities for the 2013 tax year? I don't know. In my experience logic and the tax code
    don't belong in the same sentence, much less the same article, and thus far I have not heard anyone say that is possible. I am hoping someone familiar with REIT tax laws can explain this to me, because this is may greatest concern. Remember, the forced selling of distressed assets is what got the banks in trouble and could easily happen here.

    Conclusion

    AGNC's business model really isn't that complicated. They borrow at x rate and re-invest at (x + y) rate. As long as rates don't move more than their current spread (1.5%), VERY QUICKLY, they will make money. It really is that simple.

    That said, be prepared for major swings in the equity's valuation as earnings and dividend payments fly all over the place when crap hits the fan. Their overpayment situation has put them in a pickle and if they are forced to pay current year dividend liabilities that are higher than current year income, they may have to sell distressed assets ala banks 2008 and kaboom goes the stock. I really wish they limited dividend payments to actual liability. The spread-leverage model works and this vehicle exposes average investors to a financial instrument that was once only available to banks.

    I am still holding my (AGNC) and (MTGE), but am removing the DRIP option and considering dumping altogether in favor of pipeline stocks.

    Disclosure: I am long AGNC, MTGE.

    May 03 5:11 PM | Link | 31 Comments
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