American Capital Agency: Let's Be Honest
Let's look at the reality of the American Capital Agency (AGNC) situation. It has plummeted in 2013, which has primarily been in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year. Second was the fear that rising interest rates will crush portfolio holdings of the mortgage real estate investment trusts (mREITS). Third, there have been some true issues with quarterly performances.
In this article, I will discuss and put into perspective AGNC's most recent quarter and lay out why I believe shares are undervalued and heading higher. I most recently opined on the stock in July when it got hammered after a better-than-expected jobs number showing that the market added 195,000 jobs in June. That day, when AGNC was trading down 7.5% at $20.21, I came out with a call to buy the panic selling. After reviewing the quarterly report closely and being asked by several readers my overall opinion, I'd like to go over the key takeaways that investors should focus on to honestly assess if my decision to buy this stock on the way down was wise.
Key Headline Statistics From Earnings -- To Be Honest, It Was Awful-Looking
A lot of traders move stocks based on the headline numbers only. While I agree those are important as they give you an indication of the company's performance, they can be misleading at times. However, I would be remiss if I did not provide them. Overall, it looked pretty ugly at first. AGNC reported a nasty $2.37 comprehensive loss per common share, comprised of $4.61 in net income per common share as well as a $6.98 other comprehensive loss per common share. This equates to an overall loss of $936 million for the quarter. While the news left a lot to be desired, we really need to look under the hood to understand where we are going from here.
The All-Important Spread on Interest Rates
With interest rates moving wildly during the quarter ending in June, I had honestly expected the interest rate spread to actually improve as I saw the cost of borrowing rise slower than the yield being returned from investments. Well, I was wrong. The interest rate spread was essentially stagnant. To my surprise, AGNC reported a net interest rate spread of 1.86%. Basically, it didn't change from the first quarter at all, which was reported 1.87%. If we exclude TBA dollar roll income, then AGNC's net spread was 1.49% -- essentially the same as Q1, which was reported as 1.51%.
Let's look at this a bit more to see where the assets and yields stand. First, AGNC's asset yield on its agency security portfolio for the quarter was 2.92%, compared to 2.80% for the first quarter. The annualized weighted average yield on the agency security portfolio was 2.63% for the current quarter, compared to 2.64% for the prior quarter, backing out the amortization catch-up payments. Overall, AGNC's average asset yield reported as of June 30, 2013, was 2.71%, a four-basis-point decrease from 2.75% as of March 31, 2013. Furthermore, AGNC's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 15 basis points to 1.43% for the second quarter, from 1.28% for the first quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter. As a result, the average cost of funds as of June 30, 2013, increased 15 basis points to 1.47% from 1.32% as of March 31, 2013.
To put this all into perspective, the cost to borrow rose but the average yields did as well. Thus, earnings potentials as a result from the interest rate spread alone have not changed. In fact, 1.5% for the overall spread is rather strong, though as investors we want this number to be as high as possible. This statistic is one of the first things I examine when looking the performance of any mREIT. Overall, it wasn't that bad, but I expected the spread to widen.
The Dividend
While we have known about the declared dividend for a while when it was announced in June, let's look under the hood of this number a bit. To be honest, I didn't think AGNC could afford it. I was worried. The dividend of $1.05 per share was down 16% from the last dividend of $1.25 per share. It should be noted that this number was actually better than expected as it was widely believed that the dividend was going to be cut to a dollar or less. Some were opining it could drop as low as $0.80.
Looking under the hood now, it would appear that the dividend wasmore than AGNC's estimated taxable income per share of $1.04. However, digging a little deeper, we see that the $1.05 payment per share is less than AGNC's net spread and dollar roll income. That figure is approximately $1.15 per share. While the dividend paid was definitely up against this number, AGNC did have sufficient cash to pay it. At a current share price of $22.59, this represents a still sizable yield that AGNC has been known for of 18.6%. It is important to note that this dividend can certainly fluctuate moving forward, but now that interest rates movements have calmed down, it is likely that we can expect this dividend to stay at current levels for the time being.
It's Still All About Book Value
I recently opined on the significance of book value for mREITs. Essentially, you want to buy when the stock trades below book value and sell when stock price gets too far ahead of book value. This assumes that book value will remain relatively stable, or in the case of buying below book value, rising. With the extreme volatility over the last few months, book value was anyone's guess. But my readers know that I was adamant that AGNC was trading well below book value. Well, as it turns out, book value dropped as expected, but as of June 30 the stock was indeed trading well below tangible book value.
On June 30, the stock was trading around $23.00. The book value was reported to be $25.51, which was a $3.28 drop from the end of Q1. However, it also meant that the stock was trading about 12% below book value, indicating at the time it was a great buy. Much of this decline was due to the volatility in the mortgage-backed securities (MBS), and such many investors and traders we just dumping the stock for fear that it could have been much worse. Considering the stabilization in MBS prices, and interest rates over the last few weeks, we can likely safely conclude that book value at the moment has stabilized as well. Therefore, it is likely we are still trading at a significant discount to book value, and thus we have a buying opportunity in the name still.
The Fed Is No Reason to Worry
As we can see, AGNC can stand on its own two feet. It was a transitional quarter and being a shareholder has been painful. I began accumulating and completing a position on the way down. During this time, a lot of criticisms I received were surrounding the Fed and how devastating its exit will be. Let me be clear: Upon the release of the June FOMC meeting minutes, combined with Ben Bernanke's comments in Boston following their release, it is clear that every member except one had advocated for an extension of the Fed's current economic stimulus program. This week the Fed met once again, and their accommodative stance remains in place because the economic data just isn't that strong.
The Fed is not advocating for tapering of asset purchases ahead of stable economic news and/or meeting the economic goals laid out when the program was announced. So the fears of this issue that partially punished the mREITs are simply unfounded right now. Among the most important takeaways is that FOMC was adamant that the low-rate situation, or the zero rate interest policy (ZIRP), will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015. Furthermore, Ben Bernanke said that the current unemployment rate of 7.6% might be overstating the "health of the labor market," and as such "highly accommodative monetary policy for the foreseeable future is what's needed."
Conclusion
The quarter was tough, no doubt about it. The big headlines from earnings were pretty nasty in terms of the losses. However, two of the most important items to consider with the mREITs were reported to be strong by AGNC. First was the interest rate spread. While it did not rise as I thought it would, it didn't decline really either. It remained stagnant, but profitable nonetheless. Second was book value, the measure of which should properly determine the share price of your mREIT and be used as a basis for deciding whether to buy or sell. It declined far less than expected. As such, shares were undervalued on June 30, and are certainly still undervalued. With this evidence and two transitional quarters behind us, let's be honest -- AGNC is a buy at these level
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