NLY - Armour Residential: Why A Dividend Reset Is Likely

2023-10-09 05:22:41 ET

Summary

• ARMOUR Residential REIT is at risk of having to slash its unsustainable dividends.
• The trust's high dividend yield and large book value discount are warning signs for passive income investors.
• ARR has seen a decline in distributable earnings and deteriorating dividend coverage, indicating a change in dividend policy.

A number of mortgage real estate investment trusts are at risk of having to slash their unsustainable dividends, and ARMOUR Residential REIT Inc. ( ARR ) is one such trust.

Even though ARMOUR Residential guided for a stable dividend payout and just completed a successful five-to-one reverse stock split, the trust's payout metrics are not sustainable, and passive income investors must expect a dividend adjustment in the first quarter.

Both the high dividend yield in excess of 20% as well as the large book value discount of 31% are, in my view, warning signs, and passive income investors should not be seduced by ARMOUR Residential's yield. The trust also paid out more than 100% of its distributable earnings in the last quarter. Sell.

ARMOUR Residential Suffers From Contracting Core Earnings In A High-Cost Environment

ARMOUR Residential invests primarily in residential mortgage-backed securities that are issued or guaranteed by either the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Government National Mortgage Administration (Ginnie Mae).

ARMOUR Residential's agency securities portfolio consisted of assets valued at $11.2 billion as of the end of the second quarter.

Like other mortgage REITs, ARMOUR Residential makes its money by using low-cost debt to invest in high-yielding mortgage securities. This business model works well when borrowing costs are low, but the most recent rate-hiking cycle has thrown a bit of a wrench into this business model.

ARMOUR Residential has seen a huge increase in its funding costs and a corresponding contraction in its net interest margin in the last couple of quarters. In the second quarter, ARMOUR Residential's net interest margin declined for the fourth straight quarter, to 1.75%, amid higher interest costs. ARMOUR Residential's interest costs, net, soared from 0.66% in 2Q-22 to 2.49% in 2Q-23, reflecting a rise of 277% YoY.

This uptick in financing costs has led to a decline in distributable earnings and deteriorating dividend coverage. Following the trust's reverse stock split, I think investors are going to see a dividend cut in the first quarter as the current dividend payout is not sustainable.

In the last three quarters, a gradual deterioration of the trust's payout metrics has transpired, and ARMOUR Residential has paid out more than 100% of its distributable earnings in each of the last three quarters. Under-earning the dividend payout is typically seen as a strong indication of a change in dividend policy.

My expectation is that the mortgage trust will change its dividend in 1Q-24, before the release of full-year earnings, and seek to realign its dividend payout with its underlying distributable earnings power.

Completed Five-To-One Reverse Stock Split And Dividend Outlook

ARMOUR Residential REIT completed a reverse stock split of the trust's outstanding shares of common stock at a ratio of one-for-five at the end of September.

Companies typically conduct reverse stock splits in order to prevent the delisting of their stocks from the exchange or make their stocks trade at higher prices in order to avoid association with the riskier penny stocks (stocks trading at $5 or less).

In relation to the reverse stock split, ARMOUR Residential also adjusted its forward dividend payout. The mortgage trust said that it would pay $0.40 per share per month in the fourth quarter, which translates into an annualized dividend payout of $4.80, implying a 23% stock yield.

The dividend dates for the adjusted dividend are reproduced below.

The last time ARMOUR Residential slashed its dividend payout was in March 2023, when the mortgage REIT slashed its dividend by 20%.

Large But Deserved Book Value Discount

ARMOUR Residential's stock is selling at a 31% discount to book value, which is one of the largest book values that I have come across in covering the mortgage trust sector.

Large mortgage trusts like Annaly Capital Management Inc. ( NLY ) or AGNC Investment Corp. ( AGNC ) sell at substantially lower discounts to book value, and I have recently written about how Annaly's risk/reward situation has improved . Given the unsustainable dividend coverage trend and large discount to book value, passive income investors should avoid ARR at least until the trust has reset its dividend, in my view.

Why ARMOUR Residential Could See A Lower Or Higher Valuation Multiple

A dividend cut, at this point, may at least partially be priced into ARMOUR Residential's stock valuation. The trust is selling at a whopping 31% discount to book value, which compares against much smaller discounts for larger mortgage trusts.

A decline in net funding costs (which in turn would be a result of declining interest rates) could potentially soften the blow for this mortgage trust.

Nonetheless, I expect ARMOUR Residential to cut its dividend in the next quarter.

My Conclusion

ARMOUR Residential, in my view, is set for yet another dividend decrease in the short term, and I would think the company will announce the dividend decrease early next year, prior to the release of full-year results.

ARMOUR Residential may have successfully completed a five-to-one reverse stock split and guided for a stable dividend payout in the fourth quarter, but I consider the mortgage trust to be a serious value trap for passive income investors.

Both the high 23% yield and the large discount to book value show observant passive income investors that the dividend is set to get whacked. Avoid this mortgage trust.

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