Description

Armour Residential REIT (AMRR) is an interesting way to play the agency mortgage REIT space.  It is the cheapest of the agency mortgage REITs on a price to book basis and has the highest prospective yield.  The principal drawbacks are that this is a true microcap stock and that management may pursue a dilutive capital raise in order to gain scale.  However, if you think that the yield curve is likely to remain steep and that the agency market place will remain intact as the "credit crisis" evolves then this is high return (20% IRR) investment with limited downside.

Background

AMRR was formed as a result of a SPAC (Enterprise Acquisition) not finding an operating business to merge into and then deciding to become an agency mortgage REIT.  As a result of the SPAC "vote securing process", many of the SPAC shareholders were cashed out leaving a company with a book value of just over $20 million all of which was cash.  This cash has since been invested in agency mortgage securities.

Business

The business of agency mortgage REITs is to buy residential mortgage securities guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae.  These securities have a US Government guarantee that is either implicit or explicit.  As such, there is no credit risk.  The purchases are financed using repurchase agreements that use the securities as collateral.  Haircuts vary, but probably average around 5% implying available leverage of 20x although most of the mortgage REITs operate with leverage levels of 6-8x after allowing for unencumbered securities.  Repurchase financing is usually short term and LIBOR based.  AMRR's current rates average LIBOR + 25bps.  Most of the agency REITs will swap a portion of their repurchase agreements into fixed rate obligations in order to match expected durations for their assets.

The agency REIT business has rarely been better with most of the public companies earning 20% levered returns on equity based on the spread between financing costs and asset yields.  The principal risks in the business are interest rates and prepayments given that most agency purchases are made at a premium to par.  The current fear regarding buy-outs is essentially akin to massive prepayment risk.

Most of the agency REITs describe their businesses well in public filings.  AMRR filed an 8-K with a helpful presentation on October 1, 2009.  A useful update appears on the website www.armourreit.com from January 26, 2010.

Management

AMRR is run by Scott Ulm and Jeff Zimmer.  My due diligence on Scott has come back neutral.  However, Jeff Zimmer is a controversial character that oversaw the demise of Bimini, a mortgage REIT that did not do well after entering the mortgage origination business at pretty much the peak of the market.  Investing with Jeff may be a non-starter for some; however, after discussing AMRR with him it is clear that he is doing everything he can to make the AMRR a success, that he has a deep understanding of the agency market, and that he is anxious to make amends for his prior sins.

Valuation

Comparable companies include Annaly (NLY), Anworth (ANH), Capstead (CMO), Cypress Sharpridge (CYS), Hatteras (HTS), MFA (MFA), and Two Harbors (TWO).  MFA has become less comparable over the last year as a result of diversifying into non-agency mortgage investments.  The comparables trade at a price/book value range of 95% to 120% and a current dividend yield range of 15% to 20%.  The best comparable in terms of portfolio mix is Anworth, given its relatively high proportion of hybrids, which trades at 90% of book value with a 16% current dividend yield.  Last week, AMRR pre-announced its first quarter results and declared a 40 cent first quarter dividend.  Using the estimated 1Q book value of $9.32 per share, at a price of $8.10, AMRR trades at 87% of book value with a 20% current yield.  This is cheap.  Shudda, cudda, wudda note:  I was working on this write-up prior to this week's move.  At $7.15, I really thought this was a no-brainer.

Investment Merits

Valuation - AMRR trades at the most attractive price/book value and current yield of its peer group.  As a result, I think downside is limited and investors are being well compensated for the micro cap nature of the investment.  In addition, given that the mortgage REITs often trade at meaningful premiums to book when spreads are as high as they are, there is the upside possibility that AMRR trade up with the sector should investors re-rate the agency REITs in general.

Portfolio - One of the advantages of being small is that AMRR has the ability to "pick off" small investments at attractive prices that would not necessarily move the needle for the larger agency REITs.  With over 100 portfolio positions, there is good evidence that AMRR is doing this.  This should enhance AMRR's distributions over time.

Issues

Growth - Management wants to be bigger.  With AMRR trading at a low multiple of book, there is the risk that they do a dilutive capital raise.  They do not seem to be headed in that direction and are more focused on raising additional equity through preferred stock or warrants.

Size - This is a micro cap stock.

Management - Some investors are not going to get comfortable.

The Fed - I believe that the range of the Fed's potential actions including "withdrawal" and "tightening" are effectively priced into the agency market and the valuations for the agency mortgage REITs.  These topics have been covered to death in the media.  In addition, I think that the economy will remain weak for some time and that the spreads for the agency REITs will remain attractive for longer than people think.

Prepayments/buy-outs - I believe that fear of massive prepayments is unwarranted given the state of the housing and mortgage finance markets and that homeowner refinancing activity will remain muted for some time.  Offsetting this trend will be that of buy-outs; however, buy-outs will impact individual portfolios differently.  Relatively low coupon portfolios that contain limited exposure to 2006 and 2007 vintage mortgages such as that of AMRR should fare reasonably well.

Bottom Line

This is an attractively priced investment opportunity that has limited downside.  Should management be able to grow the company without dilution then upside exists as liquidity improves and multiples trend toward those of larger peers.  However, if growth is not possible and management decides to wind things down, realization of book value is not an unreasonable possibility.  With current book at $9.32 and the stock at $8.10, that is an attractive option.

Catalyst

Specific catalysts are tough with this one although they include: 1. increased investor attention 2. a rerating of the sector once investors realize that spreads should stay wide for some time and 3. management decides to liquidate.