In this column, we review critical metrics associated with the name, and assess whether TWO’s recently raised dividend back to $0.26 is being covered. Further, we will discuss our take on the stock at present levels. The key metrics which you should examine for all mREITs are summarized below for TWO:
Table 1. Summary of Key Metrics of Two Harbors as of Q3 2017
|Key Metrics of Interest||Two’s Performance|
|Q3 2017 Book value and % change from Q3 2016||$20.12 (1.9%)|
|Net interest rate spread in Q3||2.07%|
|Dividend (yield)*||$0.52 (13.6%)|
|Q3 Core Income Per Share||$0.51|
|52-week share price range||$15.21-$21.08|
*Based on current share price and forward annualized yield
**Determination based on estimate of core earnings covering dividend paid
Data table source: TWO’s Q3 earnings
TWO had a quarter that was weaker than we projected on several fronts, especially considering the momentum we had in Q2. First, we want to point out that the company slightly exceeded our expectations on the top line. We were looking for a bullish outcome of $113 million, while the company reported $115.3 million. This strength was welcomed. This net interest income figure was up 6% from last year’s $108 million.
This figure is important because it does show a return to growth in this transitional quarter. While net interest income was strong, the best gauge for dividend coverage is, of course, core earnings. We were looking for $0.52, which would be just enough to cover the dividend. As it turns out, they came in at $89.2 million $0.51 per share. The key here is the dividend was not covered. Thankfully last quarter, core earnings came in at $97.5 million or a strong $0.56 per share, which provided a cushion (so called ‘spillback’ coverage). This result missed our estimates by $0.01 and led to a $0.01 shortfall in the payout. With these results, what is going on with the key metrics?
Net interest rate spread
Compared a to a few years ago the key metrics are still under pressure. One critical indicator to look at is the net interest rate spread, which is a gauge for potential earnings power of an mREIT. We arrive at this measure by taking the difference of the yield on assets, and the cost to acquire those asserts
That said, the annualized yield on the company’s portfolio assets was 3.90%, down just a hair from 3.96% in Q2 2017. Unfortunately, the annualized cost of funds rose 23 basis points to 1.83% from, from 1.60%. This is the classic double whammy, where yields decline and costs rise, severely pressuring the net interest rate spread. With these figures, we were surprised slightly by net interest income being so high, but is likely due to a stronger first half of the quarter. If we take the difference of these two variables, it results in a net interest rate spread that fell from 2.36% to 2.07%.
Constant prepayment rates
Why did the spread’s move so much? One answer is the constant prepayment rate. The big surprise this quarter? The constant prepayment rate once again rose. The last two quarters have seen increasing prepayments, somewhat bucking the trend of the overall sector.
Recall that the constant prepayment rate fell from 9.7% In Q3 2016 to 7.1% in Q4 2016 quarter, and then fell again to 5.6% in Q1. Last quarter, in Q2 it spiked to 8.0%. In the present quarter, it rose slightly again to 8.1%, which helped contributed to the pressure we saw on the yields and subsequently the spread.
Book value drives the share price of mREITs in conjunction with the dividends, and of course, momentum in the sector. More importantly we like to examine book value to determine if an mREIT is a discount, at a premium, or fairly valued. TWO saw book value gains this quarter of 1.9%, rising from $19.74 (on a split-adjusted basis) in Q2, to $20.12. This gain was pretty significant from our viewpoint, however the stock is still on a major sale here, but there is a reason.
This stock has been trading at a discount for some time and rightfully so because there were questions over its performance and of course the Granite Point issue. As reported, the stock is trading much lower price than stated book value because there is pressure in the key metrics are no longer improving, and in some cases worsening.
At the current share price of $15.32, the discount has widened slightly when we factor the rise in book value on an unadjusted basis. The stock now trades at a $4.80, or an 24% discount. That is a strong discount, even if the key metrics are under pressure.
Post reader comments–an adjusted book value metric
One of the reasons we love writing here is the comments we receive. In this case, it was brought to our attention that while the company reported book value of $20.12, management issued an adjusted figure and caution in a post earnings presentation. Here is the slide in question:
As you can see, if we want to make a proper comparison we should be using the so-called standalone, or adjusted number. Based on this figure, the actual discount-to-book is sizable at 6%, but not nearly as large as the over 20% as reported (consolidated) figure that is reported in most places.
Our view on the stock
Despite our initial take on the book value, while the key metrics of many names in the sector are improving, Two is facing some pressure. At 24% on a consolidated basis, but more appropriately at 6% on the adjusted basis, the name trades at an attractive discount. At a time when other stocks in the sector are trading at a premium, or at book value, we feel this discount is inappropriate given how many of these competitors are struggling to cover their dividends relatively speaking, are trading at book or at a discount-to-book. When we consider the rise in book value in conjunction rising rates over time, we feel the stock can be speculatively bought at present levels for risk tolerant longer-term investors.
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