mREITs' Less-Than-Stellar Quarter: One Diamond In The Rough

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 |  Includes: AGNC, DX, MTGE, NLY
by: Cash King

Summary

Annaly Capital Management, Inc. had a huge drop in spread from 1.43% to 0.90%.

American Capital Mortgage Investment is a buy at a decent discount to book value.

Leverage is up (mostly) and CPR is down. Next quarter could be a stellar quarter.

Introduction

The mREITs have had a relatively quiet ride regarding rates over the last three months; however, their share prices have taken a nice climb. I'm not sure all this price appreciation was warranted necessarily. I believe a good portion of it was the market coming to its senses and realizing it was unfairly treating the mREITs before and thus they were undervalued.

I'll look at the four mREITs I follow and how their recent quarterly reports reflect on them and the sector as a whole.

I'll look at Annaly Capital Management, Inc. (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), Dynex Capital Inc. (NYSE:DX), and American Capital Mortgage Investment (NASDAQ:MTGE).

The Facts

NLY

AGNC

DX

MTGE

BV 1st Quarter end

$12.30

$24.49

$8.87

$21.78

BV 4th Quarter end

$12.13

$23.93

$8.69

$21.47

Closing price May 9, 2014

$11.62

$23.10

$8.46

$19.98

Spread 1st Quarter

0.90%

1.43%

1.88%

2.29%

Spread 4th Quarter

1.43%

1.39%

1.77%

2.30%

1st Qtr Est. Taxable inc(Core Earnings)

$0.23

$0.47

$0.25

$0.61

1st Qtr Undistributed Taxable Inc

Unk

$0.42

Unk

$0.73

4th Qtr Undistributed Taxable Inc

Unk

$0.59

Unk

$0.77

12-month FFO (thru 1st Qtr)

-4.71 B

2.47 B

208.8 Mil (Q4)

226.1 Mil

12-month dividends (thru 1st Qtr)

1.50 B

1.47 B

69.3 Mil (Q4)

168.3 Mil

1st Quarter dividend

$0.30

$0.65

$0.25

$0.65

Stock buybacks (2013)+(2014)

(40.3 mil) + (3.4 mil)

(7.6 mil) + (0.2 mil)

1st Qtr leverage

5.2x

7.6x

Unk (reduced)

5.8x

4th Qtr leverage

5.0x

7.5x

Unk

4.42x

1st Qtr CPR

6%

7%

10.3%

5.7%

4th Qtr CPR

7%

8%

11.7%

5.7%

My Recommendation

Hold

Hold

Hold

Buy

Click to enlarge

(Source: Cash King)

First, Book value: For a long time these mREITs have been trading at a significant discount to book value. This discount has decreased but they are still trading at a small discount. NLY is trading at a 5.5% discount, AGNC at a 5.6% discount, DX at a 4.6% discount, and MTGE at an 8.3% discount. I believe these are reasonable discounts given that the imminent (6 months to a decade) rising rates could put a squeeze on the mREITs. Unfortunately, no one knows the future and when and how fast rates will rise. The economy is not chugging along like we'd like so we could be in a sustained slow growth economy for a long time and raising rates anything faster than a turtle's pace could tank the economy. Slowly rising rates are great for the mREITs.

Spread: Three out of the four mREITs managed to increase or maintain their spread. NLY's spread tanked from 4th quarter to 1st quarter which is not a good sign for them.

Taxable Income (Core Income): Taxable Income or Core Income in all cases was either right at or below the dividend levels. This caused Undistributed Taxable income to also fall in AGNC and MTGE. This cannot be sustained indefinitely and needs to be rectified.

Funds from Operations (FFO): Funds from operations over the last 12 months vs. dividends paid over the last 12 months looks promising for all mREITs other than NLY. AGNC and MTGE have been aggressively buying back stock and this has clearly helped them. Their quarterly dividends paid have been dropping significantly both because dividends were reduced but also because of fewer shares to pay out on. NLY again has a red flag raised.

Buybacks: AGNC and MTGE have slowed down the pace of buybacks which makes sense as the share price has increased closer to book value. This has already provided a significant benefit in fewer dividends paid and other areas.

Leverage: Three out of the four mREITs increased leverage slightly in the first quarter with DX reducing it. I was unable to find exact numbers for DX's leverage but did find a statement saying it had been reduced. This increased leverage should help them profit going forward.

Constant Prepayment Rate (CPR): The CPR for all four either stayed constant or decreased which is good. We want prepayments as low as possible that way we benefit from the interest being paid on the loans.

My Recommendation: I personally tend to not sell as I'm accumulating AND using these as income producers. Unless that income producing is significantly degraded I'll withstand the fluctuations and the fear. On that note I barely ever sell or recommend a sell. NLY, AGNC, and DX I have as a hold. Also, being a value investor I tend to only buy on fear induced swings in stock price. At current prices AGNC, DX, and NLY are only slightly undervalued. This slight undervaluation is not enough in my opinion to buy considering their slight underperformance in a relatively stable and what should have been in my opinion a good quarter. NLY because of its significant FFO vs. dividend discrepancy and its tanking spread is closer to a sell. If I were the selling type I might consider NLY a sell if it went up a tad on price in order to lock in some more gains from my recent low purchases. Since I'm not the selling type though I'll remain patient, see what next quarter brings, and collect the decent income I'm receiving.

MTGE did not have a fantastic quarter but in my opinion I believe they faired pretty well compared to the others. They are also slightly more undervalued compared to the others. I will not be buying more because of trying to keep my allocation in my portfolio right but if I could buy more I would be. I'm already overweight on them as well. They maintained a relatively high spread, their core earnings are ever so close to supporting their dividend, their leverage bumped up in the quarter, and their FFO vs. dividends is impressive.

Going Forward

The biggest elephant in the room for mREITs is rising rates. As I mentioned earlier though the economy is improving at an ever so slow and uneven rate so when rising rates will happen is unknown. The reduction in QE seems to have been a nonevent so that should not have any significant effects going forward. As long as rates rise slowly then the mREITs should be ok.

The risk may be worth it, depending on your individual risk to own a few mREITs in your portfolio and enjoy the double-digit yield. I'm convinced rates will not skyrocket over night and don't foresee any huge catastrophes to mREITs anytime soon. The risk was much lower a few months ago when prices were significantly lower and yields were higher, but in some cases, and in MTGE specifically, I feel the risk vs. reward situation is relatively good.

Disclosure: I am long NLY, MTGE, AGNC, DX, MORL. 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.