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Summary

  • Company working to improve earnings, support dividends and protect book value.
  • IVR has also successfully reduced duration and exposure to rate sensitive assets.
  • Company’s recent quarter’s results show book value increased by 1.9% quarter-on-quarter to $17.97 per share.

I believe that in the prevailing industry conditions and given the ongoing tapering process, mREITs with agency exposure are likely to underperform mREITs with non-agency exposure. I am bullish on Invesco Mortgage Capital (NYSE:IVR), as the company has been taking the right measures by rebalancing its portfolio to improve earnings, support dividends and protect its book value. In recent quarters, as Treasury Yields have risen, IVR has successfully reduced its duration and exposure to rate sensitive assets.

Financial Performance
The company reported mixed financial performance for 4Q2013; IVR reported an adjusted EPS of $0.48 in the recent fourth quarter, missing consensus estimates of $0.50. Earnings for the quarter were positively affected by an increase in portfolio earnings yield of 14bps to 3.49%, due to the sale of lower yield fixed rate assets. However, cost of funds increased by 17bps to 2.14% in 4Q2013, due to forward settling swaps, which had a negative impact on the company's quarterly earnings and led to a drop in net interest margin of 3bps to 1.35%.

A positive takeaway from the recent quarter's results was the fact that book value increased by 1.9% quarter-on-quarter to $17.97 per share. Also, as the company continues to rebalance its portfolio towards less sensitive assets, its leverage increased to 7.3x in 4Q2013 as compared to 6.9x in 3Q2013. IVR maintained its swap portfolio in 4Q2013, unchanged quarter-on-quarter at $12.8 billion. However, the company's hedge for the quarter, as a percentage of repo outstanding, increased to 91.4% as compared to 89.1% in 3Q2013. The following table shows important performance metrics for IVR.

3Q2013

4Q2013

Quarter-on-Quarter Change

Year-on-Year Change

Asset Earning Yield

3.35%

3.35%

14bps

21bps

Cost of Funds

1.97%

2.14%

17bps

50bps

Net Interest Margin

1.38%

1.35%

(3)bps

(28)bps

Leverage

6.9x

7.3x

0.3x

1.2x

Book Value Per Share

$17.64

$17.97

1.9%

(14%)

Source: Company Report and Calculations

Portfolio Rebalancing - Reducing Interest Rate Exposure
As Treasury Yields continue to rise and given the inverse relationship between book value and interest rates, the company continues to lower its exposure to rate sensitive assets to protect its book value. IVR is continuously lowering its exposure to Agency portfolio and longer duration securities. In 2013, the company's exposure to Agency securities decreased to 56.8% as a percentage of total assets, down from 72.1% in 2012. Also, the company lowered its Agency 30-year securities to 61% as a percentage of total Agency assets, down from 75% in 2012. Furthermore, apart from lowering exposure to Agency and high duration securities, IVR increased its exposure to Hybrid ARM, ARM and CMBS securities. The company's efforts to diversify its portfolio away from Agency and long duration securities are likely to portend well for its future book value. The company targets to increase its portfolio of non-agency and CMBS securities to approximately 25% each. The following chart shows the lower Agency exposure in 2013, as compared to 2012.
(click to enlarge)
Source: Investors Presentation

As the company continues to rebalance its portfolio, it will look to protect its book value. Due to portfolio rebalancing efforts, the company's book value change outperformed its peers in the recent fourth quarter. The following chart shows book value changes for IVR, Two Harbors (NYSE:TWO), Dynex Capital (NYSE:DX), AG Mortgage (NYSE:MITT) and American Capital Mortgage (NASDAQ:MTGE).

Source: Companies Reports

Share Buybacks and Dividends
As the Fed continues to taper and interest rates are expected to rise by the end of upcoming years, share buybacks have become a popular option for mREITs to grow earnings and protect book values. In the 4Q2013, the company repurchased 10.7 million shares for $160.5 million, representing approximately 8% of its market capitalization. As the stock is trading at a discount to its book value (has a price to book value of 0.95x), the company is likely to continue to buy back its shares in the coming quarters.

Other than undertaking attractive buybacks, the company offers an impressive dividend yield of 11.60%. In the recent fourth quarter, the company paid a dividend of $0.50 per share and earned $0.48 per share, resulting in a high dividend coverage ratio of 104%, which I believe remains a concern for investors. I believe dividend coverage ratio for the company is likely to stay in a range of 95%-100% in the near future, and dividend coverage will improve as the company will continue to rebalance its portfolio. Earlier this week, the company declared a cash quarterly dividend of $0.50 per share for 1Q2014, flat quarter-on-quarter. The dividend is payable on April 28, 2014, with an ex-dividend date of March 27, 2014.

Conclusion
The company remains an attractive investment option for dividend-seeking investors, as the stock offers a high dividend yield of 11.60%. Also, the company has been taking correct measures to rebalance its portfolio, favoring non-agency and lower duration securities. In addition, I believe share buybacks will remain an important tool in the hands of the company to fuel EPS growth and protect its book value, as the rates are expected to rise in the near future.

Moreover, the stock offers a potential price appreciation of 5%, based on my price target of $18. I calculated the price target using IVR's four year historical average price-to-book value of 1.0x and current book value of $18. Due to the abovementioned factors, I am bullish on the stock.

Historical Price to Book Value

Current Book Value Per Share

Price Target

1.0x

$18

$18

Source: Invesco Mortgage: Efforts At Rebalancing Portfolio Set It Apart