- This mREIT pays a 10% dividend yield and is the nation's largest non-bank lender.
- Misunderstood interest rate risk and business structure has kept the stock below fair value.
- Its unique strategy should help the company excel in a rising rate environment.
- A few big name hedge funds are buying up the stock and fair value is around 20% above current levels.
Investing in mortgage originators can be tricky business. Not all are the same, and there is still a rather large stain on the mortgage industry as a whole. However, for investors on the deep value side, this is usually a great time to snap up shares for relatively cheap.
PennyMac Mortgage Investment Trust (PMT) is a mortgage REIT I have been interested in for some time. This particular REIT invests in residential mortgage loans and mortgage-related assets. PennyMac is a different beast altogether. It's U.S.'s largest non-bank lender.
It basically buys up delinquent mortgages at pennies or dimes on the dollar. They then work with the homeowner to rework the payment, making its money on the spread -- what they paid for the loan and what they'll now be getting for the loan. The bank has already taken the loss and PennyMac is merely providing a solution that doesn't involve taxpayer money.
Investors are still getting a near 10% dividend yield. Granted, that's actually below some of the major mortgage REITs that yield an average of just over 10%. However, the PennyMac story has a level of growth and value to it that makes it appealing, and not just income.
The fourth quarter missed expectations, but stock continues its climb
PennyMac managed to post a fourth quarter that showed the company earning some $0.69 per share, slightly below consensus of $0.76. However, the dividend continues to rise along with the stock price. It's now paying out $0.59 per share, after upping it from the $0.57 it paid in the fourth quarter.
One of the things holding many investors back is the continued decline in mortgage originations. During the fourth quarter, the top lenders announced a 35% decrease in originations on average. Higher mortgage rates should continue pressuring originations. However, PennyMac is combating this by making higher-yielding investments.
Being able to find under-performing loans is a big part of PennyMac's model. It continues to do well with finding acquisitions. In the fourth quarter, the company completed a $500 million acquisition of non-performing whole loans. This month, PennyMac completed an agreement to acquire another $350 million this month. During the fourth quarter they sold off over $230 million performing loans in its distressed portfolio to free up cash for higher yielding investments.
The company plans to keep trading out performing loans for non-performing loans. This is a strategy that PennyMac has developed nicely. And with the NPL market expected to remain active for the next couple years, PennyMac should be able to continue finding worthwhile investment opportunities.
A unique business model unlike other mREITs
I believe that the multiple investment strategies that PennyMac has helps differentiate it from other mREITs, as well as insulate it from interest rate sensitivity. 4Q pre-tax earnings came in at $48.4 million for investment activities and $6.3 million for correspondent lending. For the quarter, its investment activity segment revenues were up 16% Q/Q. Distressed loans are still generating solid cash flow. For 4Q, gross cash proceeds totaled nearly $88 million.
Additionally, MSRs are quickly becoming a larger part of its strategy, as their economic value improves during times of rising interest rates. Along those lines, I note that PennyMac partnered with PFSI, investing over $130 million in excess spread servicing on $20 billion of unpaid balance during 4Q, just another step in increasing its MSR business. At the end of the year, MSR assets were up to $290 million, an 8% Q/Q increase.
For its correspondent lending segment, revenues totaled $18 million, versus $18.9 million in 3Q. As well, profits grew at an accelerated level given expense reduction. The correspondent lending business is also being driven by gains on mortgage loans acquired for sale.
Interest rate sensitivity is overblown
Interest rates are one of the biggest factors that impact PennyMac's mortgage investments. However, it's not as black-and-white as most investors would like to believe. All in all, it's not a net-negative for the company when rates rise, despite the lower level of originations. When rates rise, its MBS values increase, as well as other assets, such as MSRs. The sensitivity to interest rates is ultimately mitigated by owning a variety of investments. Ultimately, a 100 basis point decline in interest rates would lead to a less than 1% loss in the company's shareholder equity.
It really comes down to interest rate management across a variety of risk profiles. Something that PennyMac is doing quite well. At its core is resolving and investing in distressed loans, which was its mission when it was founded in 2009. In the last four years, PennyMac has bought over $5 billion worth of nonperforming loans and managed to develop quite an understanding of the market and an ability to model asset class performance.
The beauty of this model is that it has previously been reserved for private equity investors. PennyMac has brought that to the everyday investor.
Not only unique, but cheap
I believe that many investors are underappreciating PennyMac's ability to drive book value and earnings growth with other investments. In 2013, PennyMac managed to grow its long-term investments by over 60% Y/Y. This comes as the company found some very appealing opportunities in the distressed loan and MSRs markets. Despite the stock price being kept in check, the debt and equity markets have been open for the business. PennyMac managed to raise equity capital in 3Q and issue convertible debt in 2Q to help fund these investments.
Even still, its leverage is also well below some other major mortgage REITs, with a leverage ratio of 1.8x and a debt-to-capital of 65%. Most major mREITs have a debt-to-capital that's in excess of 85%.
The other major mortgage REITs trade around 0.9x book value. Given its 15% return on equity, I believe a more justified multiple is around 1.35x. The average mortgage REIT only churns out a 10% ROE. At 1.35x book value, PennyMac's fair value is around $28. Couple that with its near 10% fair value and the upside for the year should be 25% to 30%.
The average S&P target is somewhere around 1950 (based on an average of the likes of RBC, UBS, Credit Suisse, Goldman, Citi, Bank of America, JPM, etc.). That puts the markets upside to only 6% from current levels. I believe the upside is very compelling for PennyMac compared to current expected returns in the market.
An alleviation of investor fears' will generate upside
It's well known by now that PennyMac founder and CEO, Stanford Kurland, is a CountryWide alum. This likely keeps some investors out of the stock. Kurland worked at Countrywide for nearly 27 years, finishing his days as the company's COO and right-hand man to CEO Angelo Mozilo's. However, Kurland has spent the last five years building up PennyMac, billing it as his way to help homeowners.
The PennyMac structure also keeps some analysts and investors scratching their heads -- between the various services and management agreements. The company helped bring a bit more transparency to its operations at the beginning of 2013 when it IPO'd PFSI, which is the locomotive of the PennyMac operations. Agreements were amended and a committee of independent members reviewed the agreements.
The business model remains strong. More transparency on the inner workings has helped attract some big name investors. Kyle Bass and his Hayman Capital, as well as Leon Cooperman and LSV Asset Management, are a few of the notables. CEO Kurland is still the largest inside owner.
And granted mortgage origination revenues have been on the decline, the slack is being made up by higher quality revenue lines, which includes interest income and gains on discounted loans. I believe that PennyMac will continue offering investors an attractive dividend, while also outperforming other mREITs thanks to its unique business model.