Fed Easing And Agency MBS Demand Will Support Sustainable Future Returns

Catalysts

About ARMOUR Residential REIT

ARMOUR Residential REIT is an externally managed real estate investment trust that invests primarily in Agency mortgage backed securities and related fixed income assets to generate income for shareholders.

What are the underlying business or industry changes driving this perspective?

• Federal Reserve easing and a potential shift toward using SOFR or similar repo based measures as a policy benchmark are expected to lower funding costs and reduce rate volatility, supporting wider economic net interest margins and more stable distributable earnings.
• Growing structural demand for Agency MBS from banks, GSEs and global investors, aided by regulatory clarity and banking deregulation, should provide a deeper bid for ARMOUR's asset class and support book value and recurring revenue from incremental deployments.
• Normalization and further tightening of swap spreads, combined with ARMOUR's heavy use of SOFR and OIS pay fixed swaps, is likely to enhance hedge effectiveness, reduce earnings volatility and support net margins as hedged ROEs in the mid teens are maintained.
• Increased issuance of lower coupon and specified MBS, alongside a deepening market for discount and prepayment protected pools, aligns with ARMOUR's asset selection tilt and should mitigate prepayment risk, helping sustain total economic return and protect book value growth.
• Improving access to equity capital, as evidenced by successful bought deals and ATM issuance, positions ARMOUR to opportunistically scale into attractive spreads during future dislocations, which can drive higher revenue and operating leverage benefits to earnings over time.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming ARMOUR Residential REIT's revenue will grow by 91.9% annually over the next 3 years.
• Analysts assume that profit margins will increase from 45.0% today to 170.7% in 3 years time.
• Analysts expect earnings to reach $1.4 billion (and earnings per share of $4.5) by about December 2028, up from $52.5 million today.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 2.2x on those 2028 earnings, down from 37.4x today. This future PE is lower than the current PE for the US Mortgage REITs industry at 13.1x.
• Analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 10.66%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• A reversal or slowing of the Federal Reserve easing cycle, for example if inflation or labor data reaccelerates, could push interest rates higher, widen funding costs and repo SOFR spreads, and compress economic net interest margins, putting sustained pressure on earnings and the sustainability of dividends over the long term.
• Current Agency MBS spreads are already near the tightest levels of the year and management is explicitly positioned for further tightening, so any renewed rate volatility or widening of MBS spreads from macro or political shocks would erode book value and reduce total economic return and distributable earnings over time.
• Refinancing activity has already exceeded last year's pace with aggregate portfolio prepayment rates rising by 19% to 9.6 CPR. A further drop in mortgage rates below 6% could accelerate prepayments, shortening asset lives and forcing reinvestment at lower yields, which would weigh on net interest income and net margins.
• High structural leverage around 8.1 times and heavy use of derivatives, including SOFR and OIS pay fixed swaps, exposes ARMOUR to funding market dislocations and hedge ineffectiveness. A stress in repo liquidity or unexpected changes in SOFR Fed funds dynamics could quickly magnify losses and reduce earnings and book value.
• The strategy of issuing large amounts of new equity through ATM programs and bought deals while also repurchasing shares relies on continued favorable market sentiment toward Agency MBS. Any prolonged downturn in sector valuations or dividend cuts could restrict capital access, limiting growth in interest earning assets and constraining revenue and earnings expansion.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $17.0 for ARMOUR Residential REIT based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $825.8 million, earnings will come to $1.4 billion, and it would be trading on a PE ratio of 2.2x, assuming you use a discount rate of 10.7%.
  
• Given the current share price of $17.58, the analyst price target of $17.0 is 3.4% lower. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.