ARR - Armour Residential Starts To Rebound And The Best May Still Be Coming

2024-01-02 05:14:42 ET

Summary

• ARMOUR Residential REIT is a mortgage REIT that offers high returns and operates by buying government agency securities on people's mortgages.
• Despite its high leverage and low price/book value, ARMOUR has a plan to hedge against market changes and has a history of paying out positive REIT earnings.
• While there are risks associated with ARMOUR's heavy reliance on mortgage-backed securities, the potential for higher yields and a turnaround in the REIT market make it a compelling investment opportunity.

I know I’ve brought it up a lot lately, but I positively love mortgage REITs (mREITs). They’re easy to understand, fun to analyze, and offer well above market average returns. I also caught a persuasive recent article about how the economic environment is expected to improve for REITs in general. Naturally, I figured it is high past time to reexamine ARMOUR Residential REIT (ARR).

I think of ARMOUR as kind of the granddaddy of all REITs, with the low price/book and the double-digit yields, combined with the huge leverage they manage to hold together. I first wrote about them way back in 2014 , It was far from the end of me following this stock, and it’s fair to say it was love at first site.

Understanding ARMOUR

A mortgage REIT, ARMOUR operates by buying large amounts of government agency securities on peoples’ mortgages, and pays for them with an equally large amount of repurchase agreements.

To put the whole thing in ARMOUR’s own words from their most recent 10-K, they use thoughtful investment to support a current yield, and superior risk-adjusted returns for their unitholders.

(source: 10-Q from the SEC)

As you can see, that’s a lot of assets and liabilities, to the point where the debt/equity is over 10. That is normally a huge red flag for any company, but ARMOUR leverages heavily and it/s not unusual for debt/equity to be higher for them then even most ambitious mREITs. They always have a plan to hedge in the event of market changes.

Even during my analysis of multiple mREITs in 2016 , ARMOUR had among the highest debt/equity ratios, and an even higher assets/equity ratio, right at the tops for the largest mREITs. The company concedes in SEC filings that this is by design, and this heavy leverage is expected to continue. When the markets are strong for REITs in general, this is not a bad thing.

Another thing that’s been mostly true for ARMOUR throughout history is that tiny price/book value. Weighing in at just 0.82 we’re able to buy shareholder equity at a discount. The modified P/E ratio is also extremely low, pointing to a value proposition.

It’s tough to quantify that, but in the 10-K ARMOUR says to remain a REIT they are mostly required to pay 90% minimum of their REIT taxable earnings, and make it a habit to pay 100%. With a 12.8% yield, even if the filings show a “net loss,” it is clear that the REIT earnings are not nearly so much a "comprehensive loss."

This becomes even more apparent when we look at the Q3 10-Q for 2023. Accrued interest receivable, an asset, was up more than $200 million, whereas the liability of accrued interest payable was up only $11 million from the same time last year. Dividend payouts more than doubled from $1.20 in 2022 to $2.48 in 2023.

Even factoring in the net loss on paper in the book value for 2023, total stockholder equity was up over $100 million from last year. This is reflective of an almost $250 million increase in the value of derivatives, and even with the higher return of payouts to investors, ARMOUR was able to increase cash on hand by $50 million on top of that.

In the end, the distributions to stockholders continues in 2023 to dwarf the net loss shown on paper, with both growing at roughly the same rate year over year. The loss from the sale of Agency Securities is offset at least partially by the realized gain on derivatives, as well as the net interest income. If one just factors in gain on derivatives and their continued increased in value, it more than offsets the Agency Securities losses. Even those agency securities are still on the rise in the book in 2023, when one factors in those from dealer-broker BUCKLER.

I can't help but conclude that the paper loss is just that, on paper, and so long as distributions are rising and total assets continues to outpace total liability, ARMOUR is in good shape indeed, and making something of a de facto gain, if not an altogether easy one to quantify.

Speaking of Yields

It’s been a tough few years for REITs in 2020-2022. High interest rates, Covid, fears of inflation absolutely forced a big decline in payouts and a drop in share price across the board. ARMOUR was no different, but going back to a higher yield already is a starting sign of the turnaround. The prediction of lower interest rates could further enhance everything to the good old days of yields in the teens.

High yield and low PE sets the stage for a lot of nice time for REITs, and ARMOUR could really be a star in this regard, ready to retest the highs of recent years.

The Risks

More than a lot of companies, ARMOUR goes crazy in the 10-K with spelling out potential risks. Several pages of warnings are set out for us, and while some of them are rather unrealistic, they make for good reading, and a good opportunity to be aware of the ins and outs of the business.

ARMOUR’s assets are built heavily around mortgage-backed securities (MBS). This is how income is generated, hedged for interest rate changes. If the market got suddenly too bad though, ARMOUR warns that they might have to start selling the MBS at distressed prices. Bad for book value, bad for the bottom line.

In a rough environment they may also struggle to make the attractive portfolio investments that the total assets sheet is so stacked with. A fraction of the MBS expire at times and need to be replaced, and that might not always be easy.

The high leverage that gives us the gaudy debt/equity is also necessary to support loading up with all those MBS. In the wrong environment, the market might just not support them taking such a high leverage and that too could make replacing what they’ve already got tricky.

One of the sillier risks, in my opinion, is that of stock buybacks at prices below the book value, saying it could cost the sellers some assets. Buybacks usually ought to be done at lower prices, just like investing, and while reducing the units outstanding will also go down and so too shall remaining price/book. True and all, but upping the volume with direct buybacks should also be a bullish signal to stock prices, and could be a good thing in the long run.

By the Numbers

(source: 10-K from SEC)

Income generated by interest is, of course, ARMOUR’s bread and butter. The losses on Agency Securities have been on the rise as the REIT economy hasn’t been great. This has led to a comprehensive loss each of the last three full years, while dividends dropped a fair bit.

Like I said above, the loss is a bit misleading, as the dividends end up coming from profits and show that there is a de facto profit, if not on paper.

Conclusion

Surprising no one, I’m bullish on ARMOUR. It’s really tough to get the nice dividend yield, a discount to book value, and the prospect for an industry bull market anywhere else.

The stock price is still substantially down from 52-week highs. That’s understandable, because the market over recent years was not friendly to REITs. This is expected to change, however, and if it does, we might just retest these levels.

It’s probably a mistake to get too deeply into any one stock, but ARMOUR is an absolute income beast and a compelling book value proposition. If your portfolio isn’t already packed with residential REITs and is looking for more income plays, this is absolutely a place where you can get them.

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