Penetrating Armour Residential

 | Jun 05, 2013 | 11:00 AM EDT  | Comments
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I attended Keefe Bruyette & Woods' Mortgage Finance Conference in New York on Tuesday. The highlight for me was a presentation by Armour Residential REIT (ARR), which is a core shareholding of Portfolio Guru.

Current book value is $6.35 to $6.40. Management indicated that KBW's recent estimate of $6.30 for ARR's book value was low and Portfolio Guru's estimate of $6.47 was high. Co-CEOs Scott Ulm and Jeffrey Zimmer emphasized the detailed nature of the portfolio reports they receive every morning, so we can assume that "real-time" book value of equity per share for ARR is $6.35 to $6.40. Thus, Tuesday's closing value of $5.01 per share represents a huge discount to book of 21%.

The dividend is likely to be maintained at a $0.07 monthly rate. Management noted that while defending book value is their top priority, the factors driving the dividend are moving favorably. Ulm reiterated that prepayment costs are ARR's largest expense, and he described the recent decline in the prepayment rate as "a nice win" for ARR's ability to maintain the current dividend.

Prepayment speeds have declined to near 10% from the first quarter's average of 16%, and with asset yield compression also having abated, that would indicate the dividend has bottomed.

ARR will announce its third-quarter monthly dividend rate later this month, essentially, forecasting earnings for the July-September quarter. CFO Jim Mountain made a great point: Another cut in the monthly dividend (to $0.06 from $0.07) would indicate an estimate of 14% lower earnings, and there is no reason to believe that will occur.

In fact, with lower prepayment speeds, the more relevant question to ask is when ARR will increase the dividend to $0.08 from $0.07. That is a mathematical possibility, but we believe management will be cautious with dividend increases, as they are wary of yo-yoing the dividend rate from quarter to quarter.

Management proactively responds to market disruptions: in yesterday's column, I noted disaster preparedness is the key issue for mREIT investors. ARR management offered an example of a recent tactical move. The company sold $2 billion worth of 30-year Fannie Mae 3% bonds when the 10-year Treasury yield hit 1.65% in April, stayed out of the market for a month (didn't reinvest prepayments) and recently took advantage of the mortgage market's plummet to buy $2 billion of newly issued 30-year Fannie Mae 3.5% paper. So, ARR is reacting to both positive and negative market fluctuations, and that is reassuring.

Share repurchase has begun, but is not a priority. Zimmer indicated that ARR had begun to buy back shares under its authorization from December 2012, as I noted last week. He noted, though, that ARR management does not consider buybacks an effective way of returning cash to shareholders. His rationale: Buying back shares adds to leverage and they don't want to excessively lever the balance sheet, and he didn't believe that ARR buybacks could significantly influence in the share price, given the recent liquidity.

It's a debatable point, but clearly a massive share repurchase is not in the cards. Ulm pointed to recent purchases of ARR common by the co-CEOs as a better indication of management's faith in ARR's prospects.

The bottom line: If you buy ARR today, you get government-guaranteed assets at a 21% discount to face value with a dividend yield (assuming a stable $0.07 monthly payout) of 16.8%.

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