Saturday, March 26, 2011

Shallow Analysis Misrepresents Accretive Issuance as "Dilution"

Today I noticed a 3/22 article at Seeking Alpha that discussed AGNC's 27m-share public offering announcement (Seeking Alpha says 27m, but ACAS says 28m plus over-allotments up to 32.2m).

The stupid part of the article isn't getting the share count wrong, of course. The stupid part is this:
While shareholders should never like being diluted, it makes sense for AGNC to keep issuing shares to expand its holdings of securities given that shares trade at a premium to book value, which was last reported being $24.24 on February 8th. The fact that shares continue to march higher, even with the dilution, is a testament to the strength of the company's management American Capital (ACAS), and the 19% yield.
Dilution is when share issuance causes post-issuance shareholders to have less per share than before the issuance. Get it? Dilution. AGNC has been issuing shares above NAV, so that immediately after the issuance the NAV is more than before the issuance. That's not dilution, that's accretion. And no wonder people like it: as long as the same deals are available to AGNC through its ACAS-supplied management at the time of the issuance as was available at the time AGNC entered the deals that led to a NAV premium, the post-transaction NAV premium should make the whole ball of wax even more attractive.

And well it should: AGNC's transactions are in agency-backed securities in which there is no shortage, and increased transaction sizes only allows AGNC's fixed overhead to get leverage on bigger deals. Oh, wait. That's ACAS' overhead. AGNC pays ACAS a management fee based on net assets, so its overhead isn't going to change as a fraction of investment, and I am unaware of any non-ACAS overhead that is material to AGNC's operations. ACAS, on the other hand, makes bigger and bigger deals using the same management team and derives more and more profit from the operation. Its percent ownership of AGNC decreases with each issuance, but as the value of its fixed number of shares continues to swell and its management fees continue to grow, the asset manager does quite well by making the company available to more and more investors.

Fee-based asset management isn't a bad business: ask Ameriprise and Edward Jones about it. ACAS doesn't need to market very hard, though, just run the business while we bid for shares. Assuming AGNC doesn't issue any shares under over-allotments, and raises the net proceeds of $780m it anticipates, ACAS' management fee increases by nearly $10m/yr ($780m x 1.25% = $9.75m) or $813k/mo. That's quite a jump: in 2008, ACAS' entire management fee for running AGNC was $800k per quarter. Currently, with a book value over $24/share and a post-issuance share count of 92.9m (64.9m at the end of 2010 and 28m on offer, disregarding the potential for further issuance under over-allotments), ACAS' fee income for managing AGNC is over $28m/year (over $7m/q). This has grown to dwarf the dividend paid to ACAS on the 2,500,100 shares of AGNC it owned into last quarter, which at the $1.40 quarterly dividend paid $3,500,140 per quarter in dividend income ($14m/y).

ACAS has gone from having a trivial investment management fee as a bonus atop its dividend to having substantial fee income. ACAS' last annual report discloses 353.1m average diluted shares outstanding in the last quarter of 2010 (although only 342.4m outstanding). Assuming that this number remains accurate (I haven't noticed any 2011 issuance of ACAS), ACAS' post-AGNC-issuance income from its AGNC business ($28m/y) leads to per-share receipts of 7.9¢. About a penny a year is attributable to the last issuance, and the shares still trade at a premium, inviting more issuance.

Not too shabby.

ACAS isn't succeeding with AGNC by diluting investors in some share-printing Ponzi scheme, it's attracting additional investment to a strategy the investment in which has been valued by the marketplace above NAV for quite some time. Investors who buy in public offerings of new shares at prices below current market but above NAV aren't getting less than prior investors, and prior investors enjoy an increase in the assets backing each share rather than the dilution described by the article linked above. Sloppy use of language in the article tends to lead readers to believe investors are somehow being fooled by confidence into bidding up shares even as their interests are being devalued by dilutive issuance, which is just wrong, wrong, wrong.

Accretive issuance is good for AGNC owners, which is why ACAS – a former shareholder itself – has been steadily performing this very trick over and over to the delight of capital-profiting dividend investors.


Anonymous said...

ACAS sold the 2.5m shares a few months back..

Anonymous said...

On July 17, 2009, ACAS sold 2,500,000 shares of the Issuer’s Common Stock in a registered public offering. On November 11, 2010, ACAS sold its remaining 2,500,100 shares of the Issuer’s Common Stock in a private placement under Rule 144.

Jaded Consumer said...

According to the news I read at the time of the IPO, ACAS bought 5m in the IPO and another 2.5m in a private placement, for 7.5m (I'm ignoring the 100sh). The 10K I linked above shows the end-of-year 2010 AGNC holdings at $0.

With the management fee dwarfing dividend income, ACAS has apparently got what it wants: fee-based management income and regular monthly paychecks without significant capital tied up. With each accretive issuance, ACAS grows the fee income while raising book value (not diluting it). So long as price > book, issuance appears a win-win.

Ramiro said...

This is gorgeous!