FNM--Today's Argus Research Comment:
FANNIE MAE INC. (NYSE: FNM, $73.07) .........................................................................................BUY
Fannie Mae turned in solid earnings results, despite extraordinary volatility in interest rates and mortgage activity
during the quarter.
n Overall, the firm expressed confidence that it can hit the current analyst consensus of $8.00 per share in 2004 with
a weaker than average first half giving way to a stronger second half.
We think portfolio growth will be a touch higher than management’s guidance in 2004 as we believe banks will be
eager to reduce their high levels of loans and MBS amassed over the past couple of years.
We are raising our 2004 EPS forecast to $8.15 from $8.00. For 2003, we are raising our estimate to $7.30 from
$7.20. Our long-term growth rate remains 12%, essentially in line with the consensus of 12.45%.
n We rate the Financial Strength of Fannie Mae as Medium-High.
ANALYSIS
RECENT DEVELOPMENTS
BUY-rated, Focus List selection, Fannie Mae Inc. (NYSE: FNM) reported operating EPS of $1.83, about $0.08 above
the consensus, and up 13% from the $1.62 per share earned in the third quarter of last year. GAAP earnings were $2.69 per share.
GAAP earnings typically vary materially from “core” earnings due entirely due to FAS 133, an accounting rule requiring that
interest rate hedges be marked to fair value through the income statement each quarter. As rates rose this quarter, so did the value
of these hedges.
Fannie Mae turned in solid earnings results this quarter despite extraordinary volatility in interest rates and mortgage
activity during the quarter. The yield on the 10-year T-note surged 105 basis points in July and August only to drop back by 66
basis points in September.
Portfolio growth was extraordinary this quarter even as portfolio liquidations (due to the continued high levels of
refinancing) reached an all-time. The gross mortgage portfolio was up $105 billion this quarter to $917 billion. As rates plunged
and refis surged, lenders looked to offload more mortgages and MBS to Fannie Mae. Commitments at the end of the June quarter
were a record $135 million. A large portion of these loans, and many new loans, settled during the quarter bringing total purchases
by FNM to $245 billion. This more than offset a high level of liquidations and sales ($149 billion).
On the flip side, MBS held by Fannie dropped by $26 billion as liquidations outpaced new issuance. The net interest
margin dropped, as expected, by 10 basis points but the portfolio surge resulted in 21% growth in net interest income over last
year. Net interest income was largely flat with last quarter. Guaranty fee income, earned by FNM for guaranteeing the
performance of MBS owned by others, was up 32% from last year, but down slightly from last quarter as the MBS balance fell
and the fee rate fell due to an expected slowdown in refinance liquidations. Credit costs remained very low.
GROWTH ANALYSIS
Fannie Mae provides a high level of detail and color on performance and the outlook in its quarterly conference call and
Q&A session. We will discuss insights from the third-quarter conference call in this section.
First, with the commitment backlog back down to $28 billion from $130 billion in June, and with mortgage-to-debt
spreads having narrowed, Fannie Mae expects little if any portfolio growth in the fourth quarter. Still, full-year guidance for
growth in portfolio loans remains in the mid-teens, and growth in MBS in the mid-20% range.
For 2004, FNM is sticking to guidance for mid-teens portfolio growth driven by a strong purchase market, and a reduced
appetite by banks to add to their own mortgage portfolios. There could be some upside to this forecast if banks decide to sell loans
more quickly.
The net interest margin was at above-average levels of as much as 130 basis points this year. FNM expects the margin
to return to a more normal level of about 100 basis points, after briefly falling below that level in early 2004. Indeed, in this quarter
Fannie Mae earnings were knocked down by 70 cents per share due to over $900 million in losses on debt repurchases as the
company retired higher coupon debt. The company expects these costs to be substantially lower in 2004. The company also
expects administrative expense costs to slow to a mid-single digit pace in 2004 as activity slows. Finally, credit costs are expected
to be higher in 2004, but over an extraordinarily low base.
Overall, the firm expressed confidence that it can hit the current analyst consensus of $8.00 per share in 2004 with a
weaker-than-average first half giving way to a stronger second half.
We think portfolio growth will be a touch higher than management’s guidance in 2004 as we believe banks will be eager
to reduce their high levels of loans and MBS amassed over the past couple of years.
Thus, we are raising our 2004 EPS forecast to $8.15 from $8.00. For 2003, we are raising our estimate to $7.30 from
$7.20.
FNM’s long-term EPS growth guidance also remains intact, though the firm seems to have widened, and slightly lowered,
its growth range for the overall mortgage market. FNM now expects mortgage debt outstanding to grow between 7% and 9.5%
per year through the end of the decade. FNM expects to outpace this growth rate through gains in efficiency and market share.
Our long-term growth rate remains 12%, essentially in line with the consensus of 12.45%.
RISK ANALYSIS
In response to concerns about the company’s level of interest rate risk, FNM tightened its interest rate risk management
targets earlier this year. The company now targets an asset/liability duration gap of +/- 6 months, and it has stuck well within that
range in recent months despite extraordinary interest rate volatility.
Still, FNM’s interest rate derivatives portfolio is enormous and the risks of mismanagement are ever present.
Fannie Mae’s relatively low levels of capital and loan loss reserves also subject the company to loss if credit quality were
to take a steep slide. There have been no signs of a slide, however, and an improving economy and job market may indeed help
credit quality. Even still, with losses so negligible, there is no upside potential for FNM earnings due to better credit, in sharp
contrast to the large banks getting big earnings boosts from credit quality improvement this quarter.
Finally, Congress continues to deliberate a bill that would move Fannie and Freddie’s regulatory oversight to the
Treasury Department. The focus right now is on what powers Treasury would have over Fan and Fred’s operations. Obviously,
Fan is intent on seeing that there are no fundamental changes in the firm’s GSE charter or mission. It also does not appear that
the firms will be required to significantly increase capital, a proposal that was floated earlier this year. Our sense is that the ultimate
bill may not get passed before the end of the legislative session this year, and even when it does, the new regulatory structure should
not be as damaging to both Fan and Fred as was feared not long after the Freddie Mac scandal broke.
VALUATION & CONCLUSION
Fannie Mae trades at just 9-times our above-consensus EPS forecast for 2004, with a solid 2.5% dividend yield and a
payout ratio of just 25% of 2003 earnings. Our DCF model puts the fair value of the FNM shares at near $100 per share, but we
feel that the risks and issues inherent with the company justify a haircut to our $85 target price. Our target represents about 15%
appreciation from current levels with a below-market beta.
Don’t be fooled by that low beta, however. The FNM shares go through volatile stretches so investors with a short-time
horizon should keep the shares on a short leash. For example, between early June and mid-August, the shares fell from $75 to
MARKET DIGEST
$60 (due in large part to the Freddie scandal), and are now back near $74.
In our view, investors are taking a dim view of the mortgage business right now after two plus years of extraordinary
growth and, at times, volatility. As such, we think that growth expectations are low and Fannie has proven again this year its ability
to grow solidly under the most difficult of circumstances. We think that some upside earnings results for Fannie Mae will drive
the stock higher in 2004.
On Friday, the BUY rate FNM shares closed at $73.07, up 0.72. (David Ritter, 10/17/03) |
