AAIC - Arlington Asset Investment Corp: Price Hike Due To Acquisition Deal

2023-09-13 17:07:54 ET

Summary

• Arlington Asset Investment Corp. invests in mortgage-backed assets and has not paid dividends since the start of the COVID pandemic.
• Arlington has been able to generate consistent operating income and has a debt-to-equity ratio of 2.67.
• Ellington Financial LLC has entered into a merger agreement to acquire Arlington, offering a premium to Arlington shareholders and expecting to benefit from Arlington's assets.

~ by Snehasish Chaudhuri, MBA (Finance).

Arlington Asset Investment Corp. ( AAIC ) is a real estate investment trust, or REIT, that invests primarily in mortgage backed assets. Its capital structure is composed of unsecured debt and preferred equities. The firm used to pay regular quarterly dividends. But since the start of the COVID pandemic during March 2020, this mortgage REIT has not paid any dividend. It generates an earnings per share ((EPS)) in between $0.25 and $0.3, and trades at a price to earnings ( P/E ) ratio of around 15x. AAIC’s stock witnessed a price hike of almost 75 percent since the firm has been offered an acquisition deal. However, over the past four weeks, the price has settled down, and I don't see any major scope of a major price rise, as AAIC’s current market price is almost at par with what has been agreed upon in the acquisition deal.

AAIC Has Been Able To Generate Notable Operating Income On A Consistent Basis

Arlington Asset Investment Corp. allocates its investment among mortgage servicing right ("MSR") related assets, agency mortgage-backed securities, credit investments and single-family residential properties. AAIC acquires residential mortgage-backed securities ("RMBS"), issued by either government agencies or guaranteed by government agencies or government-sponsored entities. On June 30, 2023, the company had a book value of $6.64 per common share. MSR related assets accounted for 43 percent of AAIC’s total investment allocation and 66 percent of invested capital allocation. During Q2, 2023, MSR assets generated a weighted average yield of 13.79 percent. All such MSR loans were held by federally backed home mortgage companies (Fannie Mae & Freddie Mac) with a weighted average loan age of 32 months.

Arlington Asset Investment Corp. has a debt/equity (D/E) ratio of 2.67, which is well under control with respect to a mortgage REIT. The best part about Arlington is that it has been able to generate substantial operating income on a consistent basis. Market capitalization reached very low to almost $75 million almost five months back. But after the strong rally during the months of June and July, 2023, AAIC’s market capitalization reached almost $135 million. Overall, AAIC is a small-size mortgage REIT, which otherwise would not have generated much attention if there was no acquisition deal in place.

EFC Is Eyeing AAIC’s Low-Coupon MSRs, Attractive Long-Term Debt And Preferreds

Only a few months back, Ellington Financial Inc. ( EFC ), an affiliate of Ellington Management Group, L.L.C., entered into a definitive agreement to acquire AAIC in a stock-and-cash transaction. The transaction has been unanimously approved by both the companies’ boards of directors. EFC invests in a diverse array of financial assets including residential and commercial mortgage loans. AAIC common shareholders were offered a huge premium with respect to the market price prevailing at that point. EFC will continue to manage the combined entity with a pro forma combined market capitalization in excess of $1.0 billion. EFC will benefit immensely from AAIC’s low-coupon MSRs and attractive long-term unsecured debt and preferred stocks. This merger will enhance the scale and liquidity of the combined entity, and also the operating efficiencies as their fixed expenses will spread over a much larger equity base.

Merger Deal Offered By EFC Seems To Be Attractive For AAIC’s Equity Shareholders

As per the deal between Arlington Asset Investment and Ellington Financial (i) each share of AAIC’s common stock will be converted into 0.3619 shares of EFC’s common stock, or approximately 11.7 million shares of EFC common stock in the aggregate, and (ii) AAIC shareholders will also receive $3 million ($0.09 per share) in cash to be contributed by EFC's external manager. The respective closing stock prices for EFC and AAIC on May 26, 2023 implied an offer price of $4.77 per AAIC common share, that’s a 73 percent premium, and a 15 percent discount to AAIC’s diluted tangible book value ((BV)) per share. AAIC’s share price rose to $4.77 within less than 8 weeks from announcement of that merger deal, and is now trading somewhere near that price only. Post the merger, EFC’s shareholders are expected to own approximately 85 percent of the combined entity, while 15 percent will be held by AAIC’s shareholders.

Investment Thesis

On 30th May, 2023, Ellington Management Group, L.L.C., entered into a definitive agreement to acquire AAIC in a stock-and-cash transaction. EFC is expected to benefit from AAIC’s low-coupon MSRs and attractive long-term unsecured debt and preferred stocks. AAIC common shareholders were offered a huge premium. As per the deal 11.7 million shares of EFC common stock and $3 million cash were offered to the common shareholders of AAIC. This merger is also expected to enhance the scale, liquidity, and operating efficiency of the combined entity, which will be traded under the ticker of EFC.

Arlington Asset Investment Corp. invests primarily in mortgage backed assets, more specifically MSR related assets. The firm currently does not pay any dividend, but generates strong EPS. Its EPS is backed by significant operating income. AAIC’s stock witnessed a price hike of almost 75 percent since the firm has been offered an acquisition deal. However, over the past four weeks, price has settled down, and to some extent came down from that peak.

I don't see any major scope of a significant price rise as AAIC’s current market price is close to the acquisition price offered by Ellington Financial. Thus, buying this stock does not make any sense. However, existing shareholders must hold back on their investments, because EFC most probably will continue with their monthly dividends. At present, EFC generates a high yield of 13.5 percent.

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