ARMOUR Residential REIT (NYSE:ARR) has been a mess and I recently once again questioned the dividend safety. Recently some momentum picked up in the mREIT sector following a long, painful decline in share prices. As you are aware I have followed ARMOUR Residential REIT and have been extremely sour on the name for some time. I have urged investors against jumping in despite the massive discount-to-book for over a year. In a recent piece I stated in the article that "I think ARMOUR has started to turn the corner". I went on to say "all I ask in a name is for dividend coverage without massive book value erosion." Now as we know so much of this can be beyond the company's control (e.g. prepayments, interest rate movements) but the company can try to position itself appropriately given known and predicted circumstances. But to me it's about the dividend, and that is why we own REITs. And sadly, the dividend has been spiraling downward. But have I been too hard on the company?
I don't think so to be honest. ARMOUR had consistently been having issues covering its dividend quarter-after-quarter, resulting in multiple cuts. Remember a few months ago we learned it was cutting its dividend down to $0.27. Then of course the company cut its dividend AGAIN, to $0.22. So far the dividend has been held, but will that change? To help address this question we turn to the Q3 numbers.
To my surprise the quarter was decent. Core income, a great measure for determining income available to pay dividends, came in at $28.9 million, which was $0.68 per share. These earnings were up quarter-over-quarter from the $27.1 million last quarter. While not a measure that is as important for mREITs as core income, the company actually swung to a GAAP net income $118.7 million or $3.13 per share. The key here though is that the company's core (plus drop) income covered the dividends. However, the company was still short last quarter, so the excess was minimal. The company also paid monthly dividends in Q4 2015 of $0.171875 per outstanding share of 8.250% Series A Cumulative Redeemable Preferred Stock and $0.1640625 per outstanding share of 7.875% Series B Cumulative Redeemable Preferred Stock, resulting in payments to preferred stockholders of an aggregate of approximately $3.9 million.
Let us dig further. As most of you know by now, one of the key metrics I always look for in mREITs is the net interest rate spread because it is a proxy for the earnings power of the portfolio. In the third quarter, the annualized yield on average assets rose 1 basis point to 2.69% from 2.68% in Q2. Further the annualized cost of funds, was 1.25%, down heavily from 1.45% in Q2. The end result? The net interest spread widened to 1.44% from 1.37%. While this moved in the right direction, this is still quite low in the mREIT sector. Of course prepayments remain high at 11% so this is a metric to watch.
Of course there is always the all-important book value. Well, like others in the sector the company saw a nice rebound. But ARR did impress here. Let me remind you of the trend. ARR reported its so-called shareholder equity to be $3.96 at the end of Q2; adjusting for the reverse split this was $31.69. It fell in Q3 to just $29.05. It was down again another 3.5% to $28.00 in Q4. In Q1 2016 it got crushed and fell to $25.52. In Q2, book value jumped 4.86%. Now here in Q3 it rose another 8.5% to $27.87. It has now regained the losses from the last year. That is 100% positive.
Let's set aside past coverage of ARR. If I am looking at this quarter from a stand-alone viewpoint, I would conclude that barring the company was performing admirably. It is just reality. It was a solid quarter. Now, the yield is still stellar despite all of the dividend cuts. But the reality is also that there could be cuts coming again as core earnings, despite covering the dividend this quarter, have been consistently behind what was paid out. This is what I cannot look past. ARR will need a few quarters of coverage, and really excess coverage for me to feel good about the name. The stock does have momentum, but I still can't recommend a buy here, but if you own the stock, I would be holding. Don't buy, even with the discount, until we see sustained coverage.
Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles, which are time sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."
Disclosure: I/we 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.