Invesco Mortgage Capital Inc (IVR), a public real estate company, focuses on commercial and residential mortgage-backed securities and mortgage loans. I am bullish on the company as it has successfully managed to preserve its book value in the prevalent rising interest rate environment. It also has significant upside potential, as the company is trading at a discount to its book value. Moreover, the company is appropriately reducing its agency exposure and targeting credit assets.
In October, 200,000 fresh jobs were created, which beat analyst expectations of 120,000. Better-than-expected economic results enhance the possibility of tapering by the Fed next month. But I believe the Fed will have to look at the bigger picture, as the overall unemployment rate in October has risen to 7.3% as compared to 7.2% in the previous month. It shows that the addition of new jobs, which although managed to beat analyst expectations, was not enough to reduce the overall unemployment figures in the country. Furthermore, there has been no clear evidence that the job market is improving or not. I believe the Fed would like to see solid numbers for at least a quarter before cutting down on asset purchases.
Financial performance of 3Q'13
The company reported core EPS of $0.50, lower than analyst estimates of $0.56. It was lower than expectations because IVR has been following a more cautious approach as it wanted to minimize the deterioration of its book value. The company reduced its agency portfolio by $1 billion, as it is more exposed to the rising interest rate. Furthermore, the company has also increased its hedging, as 92% of its repo exposure is hedged as opposed to 82% in the recent second quarter. Also, IVR has also managed to reduce its duration, as it has been cutting its investment in 30-year securities, and it has been increasing its exposure to hybrid ARM's. Another encouraging sign is that the company has managed to reduce is leverage (debt-to-equity) to 7.0x from 7.6x in the second quarter of this year.
Although, I believe that the conservative approach makes more sense in the current scenario, but it has hurt its net interest margin, which reached 1.38% after experiencing a decline of 21bps. With the rising interest rate, the yield on assets increased by 10bps, but it was completely off set by a 31bps increase in the cost of funds.
The company is looking to enhance its future investment opportunity through the GSE program. CRE debt obligation is another new initiative taken by the company to unlock growth opportunities. The company is also looking to increase its exposure in credit assets, as the management believes that the spreads will tighten, which will enhance its book value.
As shown from the graph above, the company has been historically trading at a premium to its books value. However, it is currently trading at a P/BV of 0.846x due to the Fed's announcement of possible tapering in future. But the important thing to note is that the Fed has not initiated the cut down in asset purchases yet, but the market has overreacted to the news and interest rates are on the rise since the announcement earlier this year. However, IVR has successfully managed to shape up its portfolio to protect its book value. In the third quarter, IVR experienced a decline of only 1.3% as opposed to a loss of 12.4% in 2Q'13. Also, in the recent earnings release, the company reported that in the current quarter,book value was on the rise. So my price target is $17.64 based on 1xBVPS, which means we can expect price appreciation of around 18%.
IVR also offers healthy dividends of $0.50 per share (13.40%). In this quarter, the company has recently cut down on its dividends from $0.65 per share and I believe that the current $0.50 dividend per share is also under pressure, as there is no cushion available with the core EPS of $0.50. However, with the stable book value, the company can manage to increase its net interest margin, after which it might be able to support its current dividends.
The company uses short term borrowing to fund its long term assets, which means there is a duration mismatch and any disruption is the repo market could raise serious liquidity concerns. The rise in interest rates has forced IVR to adopt defensive strategies to avoid a loss in book values, and it adversely affects mortgage companies. Lastly, a deterioration of U.S. housing prices could adversely affect mortgage companies.
I believe the company has taken the right measures by opting for a defensive strategy to preserve its book value. In the recent quarter, it has experienced a rise in the book value, which will help improve its bottom line. I believe that $14.94 is a strong entry point, as IVR is trading at the bottom end of its 52-week range, and the prices are bound to recover as they converge with the book value.