In this yield-starved environment, many investors have flocked to mREITs for their double-digit dividend yields. Nearly all investors are aware of the concept of dividend sustainability and most would agree that it is a critical concern. However, there is a tremendous amount of misinformation out there in regard to how to determine sustainability. What makes matters worse is that much of this mis-information actually comes from investment professionals, CPAs and even CFAs. At the heart of the confusion is a lack of understanding of what it means to be sustainable. With so many professionals giving conflicting advice, why should you listen to me? Well, if I may be blunt, because I was right.
On March 14th, I wrote an article in which I posited that American Capital Agency's (NASDAQ:AGNC) dividend was not sustainable. In other words, AGNC would either have to cut the dividend or erode their book value to pay it. They chose the latter with a $1.25 dividend paid in April and their book value took a large hit as shown in the abysmal Q1 earnings report. I must once again blow my own horn in saying that not only was I right about what would happen, but I predicted how it would happen.
For many of you, the link will not be accessible as it was in a PRO article, which is only available to Seeking Alpha Pro subscribers, so I have copied the relevant section below.
"Sustainability of the dividend
Like most other agency mREITs, AGNC is not producing enough earnings to sustain its dividend. Upon first glance of its income statement, the REIT taxable income of $6.87 would suggest adequate coverage of the $5.00 dividend.
Notice how the dividend was only supported by the unrealized gains. Net income per common share was only $4.17, with nearly half of its income coming from the line "unrealized gain on available-for-sale-securities, Net." A gain derived from an increase in current carrying value of its securities can only translate into earnings if AGNC were to sell. The fair value of securities is always in flux and investors should not rely on their market value going up for dividend payments. If we look back at AGNC's income statements over the past five years, we can see that income from unrealized gains is all over the place and absolutely not reliable."
Now that the first quarter earnings report is out, we can see that most of the decline in book value was consequent to an unrealized loss. The point being, that market value of the securities which mREITs trade is always in flux and absolutely cannot be relied upon as a means of sustaining dividend payments.
Let us now examine precisely what it means for a dividend to be sustainable.
The meaning of sustainability
Many investors consider the sustainability of a dividend to be synonymous with "are they going to cut the dividend?" In reality, sustainability has nothing to do with whether or not the dividend is cut. It is a matter of creation versus depletion. For the purpose of this article, we can use the following as our definition.
For any process to be sustainable, the rate of resource creation must be equal to or greater than the rate of resource depletion.
For a clearer understanding, let us examine two industries: lumber and oil.
Lumber is a sustainable industry as the rate of replanting and biological growth is equal to the rate of harvesting over long periods of time. Oil is not sustainable as the rate at which the earth turns carbon into new oil deposits is far less than the rate at which we use oil. Notice how similar the oil industry is to the dividends of certain mREITs. There are enough oil reserves to maintain our current level of consumption for many years and AGNC may have enough undistributed taxable income (or UDTI) to keep the current dividend level for a few quarters, but just as we will eventually run out of oil, AGNC will run out of its UDTI reserves. Now that we have an understanding of the core concept, let us examine the sustainability of AGNC's dividend
Sustainability of the dividend
American Capital Agency is currently paying out $1.25 per quarter or $5.00 annualized. Clearly, sustaining this level would require $1.25 per quarter of sustainable earnings. What do I mean by sustainable earnings? Well, these are not the same as comprehensive income or as UDTI. It is the portion of income that is realized and recurring.
Let us take a look at their income statement to determine the sustainable earnings.
The first quarter looks far worse than it actually was. With net comprehensive ROE of -21.31% it would seem AGNC is hemorrhaging money. However, this negative number is consequent to one time mark-to-market losses and is in no way representative of its sustainable earnings. The net spread income ROE line at 11.09% is closer to accurate as it does not include mark-to-market gains and losses, but it still is not quite right.
We must add to it the realized gains/losses and the adjustment for differences in actual averages and end of month calculations. AGNC has included these as -0.85% and 0.60% respectively. Why do we include these lines in sustainable income? Well, when an unrealized loss becomes realized it actually affects their equity base such that there is less principal when it is reinvested. The same cannot be said for unrealized loss or gains where the invested principal remains unchanged. The -0.60% marked as "other miscellaneous" in the chart above is included in sustainable income as it reflects the fact that the base invested equity changed over the course of the quarter.
Making the correct inclusions shows sustainable ROE at 9.64%. While this is a very respectable return, it falls far short of sustaining the dividend. Given equity of $11.642B and an ROE of 9.64% AGNC generated $280.57mm of sustainable earnings in the first quarter. When spread over 356.2mm outstanding shares, it equates to around $0.79 per share. Clearly this is not enough to support the $1.25 quarterly dividend.
But wasn't it just a really bad quarter? No, it was actually fairly equivalent to their previous quarters in terms of sustainable earnings.
Comparison to 2012
Below is the AGNC's 2012 year end income statement.
Notice how net income per common share was $4.17 for the year, or on average $1.0425 per quarter. This portion of earnings is a decent approximation of their sustainable earnings as it does not include the unrealized gains and losses. While the 1Q $0.79 per share is somewhat lower than the $1.0425 averaged in the previous 4 quarters, it is not as huge of a difference as the Comprehensive income would have you believe.
If we look at the comprehensive income, it was $8.26 per share in 2012, or a quarterly average of $2.065. The first quarter showed comprehensive income of -$1.57/share. The difference appears enormous and I believe this is the primary reason for the harsh market reaction in which AGNC is down around 7% today (intraday 5/3/2013).
Such mark-to-market accounting is distorting the actual legitimate sustainable earnings. It is the reason why AGNC's dividend has appeared sustainable through 2012 and looks so bleak now. However, the actual sustainable earnings show a different story.
The average $1.0425 quarterly sustainable earnings in 2012 were not sufficient to sustain the dividend and the $0.79 of sustainable earnings in 1Q13 is not sufficient to sustain the dividend. The dividend was not sustainable and is still not sustainable. There was only a slight difference in quarter to quarter performance with most of the apparent defeat attributable to unrealized losses and the former unrealized gains.
Undistributed taxable income
UDTI decreased from $749mm at the end of 2012 to $430mm at 3/31/13. This equates to a decrease of $1.13 per common share to $1.08. If AGNC maintains its current sustainable earnings of $0.79, the UDTI would suggest that it will maintain the present $1.25 dividend for the next 2 quarters so as to use up the remaining portion. Such distributions, however, would be in excess of legitimate earnings and therefore at the expense of book value.
The $5.00 annual dividend was not sustainable in 2012 and is not sustainable now. We demonstrated this by showing which portion of earnings and losses was legitimately sustainable and which were 1 time events to be excluded. AGNC will either have to cut the dividend or maintain it at the expense of book value. In my opinion, cutting the dividend would be less damaging to long-term shareholders.
The above was my analysis as to the dividend's sustainability. We should also look at the viewpoint of Gary Kain.
On the Q1 conference call, Kain suggested that the reason for the loss in market value of its securities was that the market as a whole was preparing for the end to quantitative easing. He believes that QE will continue for a while and that the market prices of AGNC's securities portfolio should return to former levels. He intends to keep AGNC heavily levered until such a time when the returns are no longer worth the risk. Such high leverage will propel sustainable earnings and when combined with the expected unrealized gains, UDTI may be sufficient to maintain the dividend. When asked specifically about the dividend, Kain said that they would discuss it next month and the decision to maintain it would be based on how they felt about numerous factors including UDTI
Needless to say, his answer was somewhat ambiguous. I cannot tell whether he will or will not cut the dividend in the coming quarter, but one thing is certain: The dividend is not sustainable in the long run and it is more a question of when it will be cut than whether it will be cut.
Opportunity and going forward
What has happened in these past few days is actually a source of opportunity. The market's misunderstanding of the difference between comprehensive income and sustainable earnings has led it to interpret a slightly bad earnings report as disastrous. The losses associated with mark-to-market accounting have little effect on the company's earnings going forward and should not be given as much weight as losses to legitimate earnings. If the market's overreaction continues, and AGNC becomes discounted, it could be an excellent pickup.
At a current price of $30.61, the $5.00 dividend represents a yield in excess of 15%. While I think it may and should be cut, this does not necessarily mean it is a bad stock. It just bodes poorly for near-term performance. If the dividend is cut to a sustainable level, perhaps around $3.50 annually, and the market price is sufficiently low, I believe AGNC could be an excellent purchase.
In my opinion, $25.50 would be a strong entry point. It is around this price that the balance tips heavily in favor of the reward over the risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Disclaimer: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.