ARMOUR Residential REIT (NYSE:ARR) is an exceptionally fun mortgage REIT for analysis, though many shareholders have had anything but "fun." ARR is not that different from most other mortgage REITs with the exception that they often ran heavier leverage, were positioned unfortunately, and had an unsustainable dividend. Investors that were around for the reverse stock split will remember a slight dividend increase as 8 shares became 1 but $.04 per month became $.33 per month. Had the dividend adjusted to $.32, it would have represented no change.
Chop That Dividend
The reverse stock split occurred in summer 2015. The dividend was chopped to $.27 in April 2016. The next month, it was chopped again down to $.22 and it looked like it might be sustainable at that level. However, come January 2017, ARMOUR Residential REIT chopped the dividend again to $.19.
What You Don't Want To Do
Don't rely on insider buying. If insiders were making decisions based on material inside information, it would be a crime. It is amazing how quick investors are to disregard these laws. Insider buying should be viewed with skepticism rather than assuming it is automatically a bullish factor.
What You Want To Do
You want to project factors like book value and future earnings. Both types of estimates need to be revised at least occasionally since changes in interest rates can have a significant influence on both values.
I was able to project that the dividend was ripe for cutting. Before going into the math, I want to point out that net interest income per share is a proxy for "Core EPS" and that Core EPS is the metric many analysts will rely on when evaluating dividend sustainability.
ARMOUR Residential REIT's last estimated book value from their presentation came in at $23.53. That is near the middle of the estimates I provided for book value, but this piece is going to focus on earnings.
ARMOUR Residential REIT had 36,765,835 common shares outstanding. That gives us an estimated common equity of $865 million. They also have some preferred equity. The portfolio is (or was) leveraged to support total assets (including their interest in TBA assets) of $9,650 million. That is some massive leverage.
How ARR Hedges
The hedge portfolio has a notional balance of only $4,325 million, a weighted average maturity of 81 months, and a weighted average fixed rate of 1.79%. Since we know the weighted average is 81 months, we can convert that to 6.75 years.
What If They Want to Raise Hedges
So what happens if ARR wants to raise the hedges? Let's say, for example, they decide to add $865 million notional balance (equivalent to common equity) in new 7-year swaps. Does that seem like an extreme increase? I don't think so since the weighted average maturity was at 6.75 years already and the total notional balance was $4,325 million. Adding $865 million to that is a material increase, but it certainly doesn't qualify as huge.
How Much Would That Cost in Quarterly Interest Payments?
Further, let us assume that over the next year, the average 3-month LIBOR rate equals the recent 1-year LIBOR swap rate. The hedges would run 2.267% and the variable rate coming in would average 1.205%. The net payment per year would come out to 1.062%.
Since we know the notional balance runs $865 million and the projected net annual interest cost would be 1.062%, we can turn that into a precise cost.
The cash cost of holding that swap would run about $9.1863 million for the year.
What Does That Mean For Dividends?
Once we adjust for the number of common shares outstanding, the impact is about $.25 per share to net interest income (slight rounding error). This entire change shows up as an increase in the "Cost of Funds." Net interest income is a proxy for Core EPS. So, we need to see how that influences Core EPS and how Core EPS compares to the dividend.
Annualized Dividends and Core EPS
The annualized dividend is currently running at $2.64 per share. If we believe that the $2.64 per share previously represented roughly the entire value for net interest income available to common shareholders (similar to Core EPS), then we would see about 10% of it vanish on the hedges. That does not take into account that the unhedged cost of borrowing would also be increasing.
I would expect the increase in their cost of financing the portfolio, excluding that new swap, to slightly exceed their increase in interest income from slower amortization. Consequently, I would expect net interest income to get hit for about 10% from a change in hedging plus another negative impact from the unhedged cost of borrowing, increasing faster than the yield on assets. This leads to around 15% decline, which matches the dividend cut of nearly 15%.
I had a bearish rating on ARMOUR Residential REIT up until December 19, 2016. After shares fell by about 10% in a week, I raised the rating to neutral. Because I continued to track estimated book values (my estimates) to price ratios, I went right back to a bearish rating on December 26, 2016. With ARMOUR Residential REIT last closing at $22.20, I am confident in restating a bearish rating. I believe a more reasonable price for ARR would be in the $20 to $21 range.
If you want to learn more about investing in high yield instruments, specifically mortgage REITs and their preferred shares, why not check out the reviews from my subscribers? The Mortgage REIT Forum averages 3 articles per week. One provides updated book value estimates for several mortgage REITs and includes my ratings (adjusted each week). The second article rates the different preferred shares and shows investors which ones are offering the best bargains. The third is used to highlight individual stocks and market failures or to provide a sneak preview on the articles I'm planning to publish over the next couple weeks. If you're ready to take the plunge with a free trial, proceed straight to the Mortgage REIT Forum.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Tipranks: Assign sell rating.