A tale of two book values (AGNC and SB).

I have been concentrating on analyzing dividend records and determining the earning power of various high dividend stocks since August 2010.  But there is another major component of high dividend stock analysis: balance sheet analysis.  Today I will start a series of blog posts covering balance sheet analysis.  I will focus my efforts mostly upon American Capital Agency Corp (AGNC) and Safe Bulkers (SB).

Today I will start examining the book values of AGNC and SB.  It takes some digging in the annual reports to get accurate numbers.

AGNC book value as of December 31st, 2010 is $24.24 per share:

            Tangible assets: $14,476 M (mostly agency securities)

            Intangible assets: none

            Preferred stock: none

            Bonds: none

Minus  Total liabilities: $12,904 M (mostly repurchase agreements)

Equals shareholder equity: $1,572 M

Book value = equity / number of shares = $1,572 M / 64.856 M = a book value of $24.24 per share.

The question for AGNC becomes – How were the prices of the agency securities determined?  Mortgage backed securities are not exactly known for their price transparency.  They are somewhat toxic.  That is why the big banks off loaded them to the Federal Reserve during the financial panic of 2008-2009 and received US treasury bonds in return.  The guarantees from Fannie and Freddie will be revoked in the future due to massive US budget deficits.  I don’t trust the stability of the agency securities prices for three reasons and I will use their own words from their risk factors against them:

1) a continued depression in the housing/mortgage market hurts the value of AGNC’s agency securities.

Continued adverse developments in the broader residential mortgage market may adversely affect the value of the agency securities in which we invest.

Since 2008, the residential mortgage market in the United States has experienced a variety of unprecedented difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns. Many of these conditions are expected to continue in 2011 and beyond. Certain commercial banks, investment banks and insurance companies announced extensive losses from exposure to the residential mortgage market. These losses reduced financial industry capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated with real estate related assets, including agency securities and other high-quality residential mortgage-backed securities (“RMBS”) assets. As a result, values for RMBS assets, including some agency securities and other AAA-rated RMBS assets, have experienced a certain amount of volatility. Further increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the performance and market value of our agency securities.

We invest exclusively in agency securities (other than for hedging purposes) and rely on our agency securities as collateral for our financings. Any decline in their value, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place. Substantially all of the agency securities we invest in are classified for accounting purposes as available-for-sale. All assets classified as available-for-sale are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity. Agency securities that we invest in that are classified as trading securities are reported at fair value, with unrealized gains and losses included in current income. As a result, a decline in fair values may reduce the book value of our assets. Moreover, if the decline in fair value of an available-for-sale security is other-than-temporarily impaired, such decline will reduce earnings. If market conditions result in a decline in the fair value of our agency securities, our financial position and results of operations could be adversely affected.

2) If the Federal Reserve sells enough agency securities, then that will hurt the value of AGNC’s securities (not likely anytime soon)

Federal Reserve programs to purchase securities could have an adverse impact on the agency securities in which we invest.

Beginning in November 2008, the Federal Reserve initiated a program to purchase direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Bank and agency securities backed by Fannie Mae, Freddie Mac and Ginnie Mae. In total, this program resulted in the Federal Reserve purchasing $300 billion of direct obligations and $1.75 trillion of agency securities with the purchase program ending in the first quarter of 2010. One of the effects of this program has been to increase competition for available direct obligations and agency securities, with the result being an increase in pricing of such securities. The Federal Reserve may hold the direct obligations and agency mortgage securities to maturity or may sell them on the open market. Sales by the Federal Reserve of the direct obligations or agency mortgage securities that it currently holds may reduce the market price of such securities. Reductions in the market price of agency mortgage securities may negatively impact our book value.

In addition, the Federal Reserve initiated a program in November 2010 to purchase up to $600 billion of long-term U.S. Treasury securities by mid-2011 as part of its continuing effort to help stimulate the economy by reducing mortgage and interest rates. Such action could negatively affect our income or our net book value by impacting interest rate levels and the spread between mortgage rates and other interest rates. Thus, these actions could reduce the yields on assets that we are targeting for purchase, thereby reducing our net interest spreads. Alternatively, the Federal Reserve’s actions may not have the intended impact and could create inflation and higher interest rates. This could negatively impact our net book value or our funding cost.

3) Interest rates rise (this is likely as soon as the end of QE 2)

Because we invest in fixed-rate securities, an increase in interest rates on our borrowings may adversely affect our book value or our net interest income.

Increases in interest rates may negatively affect the market value of our agency securities. Any fixed-rate securities we invest in generally will be more negatively affected by these increases than adjustable-rate securities. In accordance with GAAP, we are required to reduce our stockholders’ equity, or book value, by the amount of any decrease in the fair value of our agency securities that are classified as available-for-sale.

Reductions in stockholders’ equity could decrease the amounts we may borrow to purchase additional agency securities, which may restrict our ability to increase our net income. Furthermore, if our funding costs are rising while our interest income is fixed, our net interest income will contract and could become negative.

Safe Bulkers (SB) book value as of December 31st, 2010 is $3.71 per share:

Tangible assets: $805.372 M (mostly 16 dry bulk ships)

Intangible assets: none

Preferred stock: none

Bonds: none

Minus  Total liabilities: $561.239 M (mostly loans for ship purchases)

Equals shareholder equity: $244.133 M

Book value = equity / number of shares = $244.133 M / 65.88 M = a book value of $3.71 per share.  I don’t see any risk factors in Safe Bulkers annual report that could affect their book value.  The prices of ships are easy to determine and their prices are very visible to those who interact with ship brokers.

* * * * * * *

Chapter 42

BALANCE-SHEET ANALYSIS.

SIGNIFICANCE OF BOOK VALUE

ON NUMEROUS OCCASIONS prior to this point we have expressed our conviction that the balance sheet deserves more attention than Wall Street has been willing to accord it for many years past. By way of introduction to this section of our work, let us list five types of information and guidance that the investor may derive from a study of the balance sheet:

1. It shows how much capital is invested in the business.

2. It reveals the ease or stringency of the company’s financial condition, i.e.,

the working-capital position.

3. It contains the details of the capitalization structure.

4. It provides an important check upon the validity of the reported earnings.

5. It supplies the basis for analyzing the sources of income.

In dealing with the first of these functions of the balance sheet, we shall begin by presenting certain definitions. The book value of a stock is the value of the assets applicable thereto as shown in the balance sheet.  It is customary to restrict this value to the tangible assets, i.e., to eliminate from the calculation such items as good-will, trade names, patents, franchises, leaseholds. The book value is also referred to as the “asset value,” and sometimes as the “tangible-asset value,” to make clear that intangibles are not included. In the case of common stocks, it is also frequently termed the “equity.”

Computation of Book Value. The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.

In many cases the following formula will be found to furnish a short cut to the answer:

= (Common Stock + Surplus Items – Intangibles) / Number of shares outstanding

By Surplus Items are meant not only items clearly marked as surplus but also premiums on capital stock and such reserves as are really part of the surplus. This would include, for example, reserves for preferred-stock retirement, for plant improvement, and for contingencies (unless known to be actually needed). Reserves of this character may be termed “Voluntary Reserves.”

* * * * * * *

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Published in: on April 13, 2011 at 4:01 pm  Leave a Comment  

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