I've covered Armour Residential REIT (ARR) in depth in prior columns, so the company's second-quarter earnings (reported last Thursday after the close) deserve scrutiny now that hysteria over the July nonfarm payrolls data has subsided. My first reaction on reading Armour Residential's 10-Q was "actually not that bad."
Not high praise, but one has to view that in context of what was obviously a difficult quarter for the mortgage REITs in general. Armour's second-quarter earnings easily exceeded my estimates, and the book value erosion in the quarter was not as bad as the recent share price performance would have predicted.
Visibility on cash flows for mortgage REITs is still low, but mortgage-backed securities price levels (as per the benchmark FNMA 30-year 3.5% coupon) are equal to those prevailing at the end of June. There hasn't been a rotation out of mortgage-backed securities since 10-year U.S. Treasury rates backed up; they were simply repriced after the initial Bernanke-driven "taper tantrum" in late-June, a process that seems to have ended.
Key items from the report:
- Book value at June quarter-end: $5.43. With Armour Residential shares currently trading at $4.44, up 2%-3% since EPS were released, it seems that the worst-case scenarios envisioned for second quarter 2013 did not occur. The 17% discount to June 30 book value shows the value opportunity still exists, though.
- Second-quarter taxable REIT income of $91.4 million was well ahead of my expectations, as prepayment expense was far milder (0.80% annualized for second quarter 2013 vs. 0.95% and 1.05% in the prior two quarters) than in recent periods. Prepayments are Armour's largest expense, and we believe the prepayment expense ratio will continue to decline in the third quarter as the back-up in mortgage rates has driven refi activity to multiyear lows.
- Driven by the stronger-than-expected taxable REIT income, Armour Residential's undistributed income as of June 30 sat at $22.9 million, or $0.06 per share. Ultimately, most of this -- it must distribute at least 90% of taxable REIT income to maintain REIT status; in 2012, it distributed 96% -- will be returned to shareholders. Armour's "nest egg" will support its ability to maintain the $0.07 current (July-September) monthly dividend rate for the fourth quarter of 2013.
- Management noted in the press release that Armour Residential sold of $4.2 billion in mortgage-backed securities after the quarter ended. The wording in the press release made it clear to me that the sales were driven by Armour's repo counterparties, as the company disclosed a $200 million loss on those divestitures. While that loss has zero impact on the company's taxable REIT income (the basis for the dividend), clearly it won't improve book value. Regaining confidence of repo partners and returning leverage to Armour's target level of 8x-9x -- the company's leverage ratio was 6.1x at the July monthly update -- will be a key driver of earnings going forward.
At Portfolio Guru, we are income investors and value dividend payout level more than a snapshot of the company's holdings. Other things equal the smaller asset base would lower Armour Residential's dividend payment by a penny per share in my estimation, but undistributed taxable REIT income and slower prepayment speeds will help forestall that in 2013. Also, any material re-levering would be supportive of the current (and even a higher) dividend level, so we eagerly await the company's August monthly portfolio update.
I am hesitant to commit my clients' dividend/interest receipts to the stock market given 2013's surge in valuation. So, we're using existing Armour Residential positions (and the monthly dividends) as an ATM to fund our purchases of attractive preferreds, including those of Armour Residential itself, which are currently trading at a discount to par.
