Buy Farmer Mac: An Earnings Oasis; A Reasonable Triple In 3 Years
By: Gary Gordon
- The company still has very low credit, interest rate, leverage and political risks despite COVID-19.
- It has a $3.20 dividend, or an astounding 7% dividend yield, and a 5 P/E.
- A fair valuation is $135, or triple the current price.
Safety in this sea of risk.
For those of you new to Farmer Mac (AGM), I describe it in detail below. For you chosen few who already know the company or just want a summary, here is an update for the coronavirus.
Credit quality should be largely unaffected. As a reminder, Farmer Mac’s loan charge-offs averaged 2 bp a year for 30 years. That may very well be the lowest charge-off rate of any lender over that period. I really don’t see that changing much this year or in the next few years, for these reasons:
- Farmer Mac’s borrowers are, oddly enough, farmers. Our lives are in turmoil right now, but we’re still eating. And farmers are already experts at social distancing. So hard to see any material change in farm revenues from domestic demand.
- The plunge in energy prices will create some nice cost reductions for farmers – lower fuel and fertilizer costs.
- China is apparently starting to live up to its promise to buy more U.S. farm products. Wheat prices are near the top of their 5-year range, while soybeans and corn are maybe only a bit below average.
- The only new risk is that farm families typically have one or more members working off the farm who could lose their job.
- Farmer Mac has some lending to rural utility cooperatives. Hard to see the utilities’ earnings plunging.
- Farmer Mac has a small portfolio of loans to other farm-related businesses like food processors. We not only want our food, we want it processed.
Funding is in great shape. Farmer Mac has a federal charter that gives it the implicit backing of the U.S. government. As such, even amid this turmoil, Farmer Mac’s borrowing rates up to 3-year maturities are only a few basis points higher than Treasuries. And while its spreads widened on longer maturities, think of the spread widening for Farmer Mac’s competitor lenders.
That’s it. That’s Farmer Mac’s exposure to COVID-19. Just about nothing.
So what do you get for the $46 you need to cough up for a share of Farmer Mac?
- A $3.20 dividend, equal to a 7% yield. And the dividend will almost assuredly increase by at least 10% a year for the foreseeable future.
- A $53 book value, so you get a 15% discount to book value.
- I estimate $9.15 per share in core EPS this year, compared to $8.72 last year, followed by $10.00 next year. Farmer Mac doesn’t provide earnings guidance, but if it did, management wouldn’t be pulling it. So you’re paying only 5 times EPS.
- Growth. Assets have been growing at about 8% a year the past four years, and should do at least that for the next few years. That’s right, growth from a 5 P/E stock.
- Future value. My $135 target price is only 13.5 times next year’s EPS estimate. That’s pretty conservative for a safe growth company.
Here’s my summary earnings model for the company: See Article
If that’s enough detail about Farmer Mac for you, stop right here and call your broker (OK, you buy online, but that’s not very visual.) If you want to learn more, read on.
What is Farmer Mac?
I’ll let the company’s 10-K do the talking (highlights mine):
“Farmer Mac is a stockholder-owned, federally chartered corporation that combines private capital and public sponsorship to serve a public purpose. Congress has charged Farmer Mac with the mission of providing a secondary market for a variety of loans made to borrowers in rural America.”
Let’s drill down into this definition by expanding on the highlighted words. First, “stockholder-owned,” but with a “public purpose.” Do we shareholders have to accept sub-par returns because of that “public purpose?” Nope:
“Farmer Mac… seeks to fulfill its mission of serving the financing needs of rural America in a way that is consistent with providing a return on the investment of its stockholders.”
And in fact, Farmer Mac has delivered mid- to high-teens ROEs through its history, including at present. “Secondary market” means that Farmer Mac does not originate its own loans. Rather, it offers these products to the originators of rural loans:
- Purchase their loans
- Lend to them, collateralized by farm mortgages and other rural assets
- Guarantee loans to create asset-backed securities.
If Farmer Mac buys loans or lends against collateral, it earns interest income. If it guarantees loans, it earns fee income.
“Borrowers in rural America” means that Farmer Mac serves farmers and farm communities, including these customer bases:
Farm and ranch mortgage loans
- Institutional owners of farm and ranch loans
- Rural utilities
- US Department of Agriculture (USDA) lenders
Here’s how the products and the customer bases intersected at the end of 2019: See Article
The special relationship – Farmer Mac’s implied government guarantee
Farmer Mac is careful to say that:
“The interest and principal on Farmer Mac’s debt obligations are not guaranteed by, and do not constitute debts or obligations of…the United States…”
But the fact is that:
“Farmer Mac is authorized to borrow up to $1.5 billion from the U.S. Treasury through the issuance of debt obligations to the U.S. Treasury.”
You can’t require the U.S. government to lend you $1.5 billion, can you? Google neither. In practice, debtholders of related government-sponsored enterprises Fannie Mae and Freddie Mac were paid timely interest and principal even when the GSEs were declared insolvent in 2008. As a result of this implied guarantee, Farmer Mac borrows at near-Treasury rates – an average of 20 bp above the 5-year Treasury in recent years. And its guarantee is considered rock-solid. This implied guarantee by the U.S. government is the core of Farmer Mac’s success.
Farmer Mac’s low risk profile. Low credit risk…
Any lending, of course, has an inherent risk of default. And lending to farmers, many of whom are in a constant struggle for survival, seems especially risky. But over the past 20 years, Farmer Mac’s loan charge-off rate averaged a microscopic 2 bp and never hit 10 bp in any single year. To see how remarkable that track record is, I compared Farmer Mac’s charge-off rate to all bank loans and to bank-owned home mortgage loans: See Article
Farmer Mac keeps its losses so low largely because:
- It requires lots of collateral. Its average farm mortgage has a loan-to-value ratio of just 45%. The company estimates that farmland values would have to fall by 56% for it to sustain significant losses. The worst farmland decline experienced since the Depression was a 23% decline during the mid-‘80s.
- Over half of Farmer Mac’s loans owned and insured have extra collateral. The $2.5 billion of USDA loans Farmer Mac insures are already insured for return of principal by the federal government. And the $9 billion of loans made to institutions are not only collateralized but are general obligations of the institution.
- It underwrites every loan. Secondary market players like Farmer Mac frequently do not underwrite the loans they buy or insure. Rather, they rely on warranties by the original originator that they did so. That is the Fannie Mae/Freddie Mac model, for example. But Farmer Mac does its own work.
- Farmers are a protected class. They receive a variety of subsidies from the government in order to stabilize their cash flow.
… And low interest rate risk…
A good definition of interest rate risk is the volatility of a financial company’s interest spread (interest income as a percent of assets) as market interest rates change. I compare Farmer Mac’s last decade interest spread to two representative peers: AGNC Investment (NASDAQ:AGNC) (another wholesale lender) and the venerable JPMorgan (NYSE:JPM): See Article
The chart makes it very clear that Farmer Mac’s interest spread is quite stable relative to peers. The key to stabilizing the interest spread is matching the duration of assets to liabilities as closely as possible. That matching requires using hedges, like interest rate swaps and callable debt. The funding benefit Farmer Mac derives from its implied government guarantee allows it to spend more on hedges than the average company. You can see the result.
“But Gordon,” you may be saying, “it’s nice that Farmer Mac’s interest spread is stable. But it’s stable at a low level.”
No, it’s not, as a critical piece of math shows. We investors ultimately focus on the income a company generates on the money we give it, measured as its return on equity (ROE). A simple conversion from interest spread to ROE is:
Another way to describe assets/equity is “leverage.” The less credit and interest rate risk a financial company has, the more it can safely leverage. The current leverage ratio of AGNC and JPMorgan is 10. That of Farmer Mac is 27. Net-net, then, while in the most recent quarter (Q2) AGNC’s ROE was 12% and JPMorgan’s was 16%, Farmer Mac delivered 17%.
… Low leverage risk…
“Low leverage risk? Are you kidding me, Gordon? You just told me that Farmer Mac is leveraged almost three times more than a bank.”
But remember Farmer Mac’s super-low credit and interest rate risk. Farmer Mac’s regulator, the Farm Credit Administration, calculates a risk-based capital level to protect against default that primarily weighs its credit and interest rate risks. As of year-end 2019, Farmer Mac had $815 million of capital. But its required risk-based capital was a mere $112 million. In reality, Farmer Mac is guided by a statutory minimum capital requirement equal to 2.75% of on-balance sheet assets and 0.75% of off-balance sheet guarantees, which it exceeds by close to $200 million at present.
… And low political/regulatory risk
As I said above, Farmer Mac’s key advantage is its implied government guarantee. Could that go away?
Highly, highly unlikely. The phrase “As American as Mom and apple pie” could easily be amended to add “and farmers.” Who wants to make life more difficult for farmers? As evidence, every change to Farmer Mac’s charter since it was founded in 1988 added to its authority. A pending change will increase its maximum farm mortgage size from 1,000 to 2,000 acres. And while our China trade war cost farmers a lot of business, the Administration quickly announced subsidies to try to offset the lost income.
Disclosure (from Gary J. Gordon): I am/we are long AGM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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