On February 6, CYS Investments (NYSE:CYS) reported its Q4 and FY 2012 results. CYS reported a net loss of $41.4 million during Q4 2012, or $0.24 per share, compared to net income of $241.0 million, or $1.46 per share, in Q3 2012. For Q4 2012 CYS had net investment income of $58.4 million and a net loss from investments of $96.0 million, compared to net investment income of $59.4 million and a net gain from investments of $221.1 million in Q3 2012. The stock for CYS has not reacted positively to this news, and has declined about 7% since the earnings announcement. The company currently has a $0.40 quarterly dividend. At current prices, CYS offers a 13% dividend yield.
FY 2012 was a fairly good year for CYS. Including the year-end special dividend of $0.52, the company paid out $2.37 in total dividends in 2012. Total GAAP net income for CYS came in at $2.64 per share. The company also had a total net realized gain from investments of $203.8M in 2012.
The price decline in shares of CYS seems to be triggered by two things: worries about the decline in Q4 of the net asset value ("NAV"), (I may also refer to NAV as book value), and concerns about a dividend reduction.
Let us first tackle the NAV decline:
As a CYS shareholder, I find it quite frustrating when the NAV decline is misrepresented. CYS saw its NAV decline 8% to $13.31 in Q4 2012, from $14.46 in Q3 2012. However, one should take into consideration the year-end special dividend of $0.52. When adjusting for this, NAV only declined 4.5% in Q4 2012. For comparison, similar agency mREITs such as American Capital Agency (NASDAQ:AGNC) and Annaly Capital (NYSE:NLY) also saw NAV declines of 2.6% and 4.5% respectively. At current prices, CYS is trading at a 9% discount to its NAV.
Next, let us look at the concerns about the dividend.
First, let us look at the key operating metrics for CYS:
The average yield on agency RMBS for CYS was 1.97% in Q4. Next, we can see that for Q4, CYS saw its interest rate spread contract to 0.94%, or 94 basis points. Finally, we can also see that the leverage ratio used by CYS was basically unchanged, staying at 7.7:1. Keep these numbers in mind, they will be very useful for understanding this next point.
CYS CEO Kevin Grant was asked during the conference call about the return on equity ("ROE") for CYS. Below I will show his response:
The CEO basically made the case for CYS having a ROE of about 10%. We can also estimate ROE. This is very easy to arrive at, first multiply 0.94% (the net interest spread) by 7.7 (the leverage). This gets you to 7.24%. Next, we add the 1.97% yield on unlevered assets. This gets us to 9.21%. 9.21% ROE is not a great number, but it isn't horrible. Next, let us multiply the ROE by the shareholder equity (total assets- total liabilities). As of Q4 2012, shareholder equity for CYS was $2.4B. This gets us to $221M. Now, we divide this by the total shares outstanding of 175M. This gets us to about $1.26 per share, or about $0.316 per quarter. This would suggest a dividend reduction of 21% from the current level of $0.40. At current prices, this would be a 10.5% yield.
How did the CEO get to the 10 or 11% ROE? For this, we need to take a look at the adjusted key metrics:
The only number we need from here is the "adjusted interest rate spread net of spread" of 1.08%. Now, let us do the above calculation again with this number. Multiply 1.08% (the adjusted net interest spread) by 7.7 (the leverage). This gets you to 8.32%. Next, we add the 1.97% yield on unlevered assets. This gets us to 10.29%. Next, let us multiply the ROE by the shareholder equity of $2.4B. This gets us to $247M. Now, we divide this by the total shares outstanding of 175M. This gets us to about $1.41 per share, or about $0.352 per quarter. This would suggest a dividend reduction of 12% from the current level of $0.40. At current prices, this would be a 11.5% yield.
Next, let us take a look at the "core earnings" and "drop income" numbers for CYS.
We can see that CYS reported $0.39 per share in core earnings plus drop income. This is still not enough to cover the $0.40 per share dividend. At current prices, this would be a 12.8% yield.
I believe that all three numbers are in agreement: A dividend reduction is coming for CYS. If I were to pick one, I would probably go with the CEO number with the 10% ROE. This leads to a quarterly dividend of about $0.35 per share. At current prices, this would give CYS a yield of 11.5%.
While I would hate to see a dividend reduction, I believe one is most likely coming for CYS. However, does a $0.05 quarterly dividend cut really merit a share price decline of nearly $1.00? CYS is currently trading at a 9% discount to book value and will probably still have a decent dividend yield. I have added to my position to CYS on this weakness.
Disclosure: I am long CYS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.