Two Harbors Investment Corp (NYSE:TWO) reported second quarter earnings on August 6, 2014 after the market closed. The earnings slightly missed analyst expectations by one cent, as the company reported core EPS of $0.24. However, I continue to remain bullish on the company because of the well diversified portfolio. Also, TWO has access to FHLB funds, which diversify its financing options and reduce its dependence on the repo market. Lastly, I believe there is significant upside potential, as the company is trading at a significant discount to its book value.
TWO missed its second quarter earnings due to lower net interest spread and ongoing expenses to build the framework for strategic initiatives. The annualized portfolio yield increased to 4.64% in the second quarter from 4.60% in the first quarter. This increase was completely off-set by a sharp rise of 10bps in cost of funds. Overall, Net Interest Margin [NIM] declined by 6bps to 3.38% in the second quarter. Agency MBS, Credit sensitive loans [CSL] and Jumbo loans experienced a rise in asset yield, whereas non-agency MBS yield declined.
Furthermore, the company also continues to maintain low exposure to interest rates. In the second quarter, the company raised its swap position by $2 billion to hedge its prime jumbo pipeline. It increased the cost of funds and hence pressurized TWO's core EPS.
In the second quarter, TWO built a $1 billion pipeline in prime jumbo loans for securitization. It also completed the securitization of another $268 million in jumbo loans in the third quarter. I believe this securitization will create an attractive investment return, which will help support the company's core EPS. Moreover, TWO added $5.3 billion in unpaid principal balance to MSR portfolio. The company recognized $33.9 million of servicing income with $6.2 million in servicing expenses. MSR yielded attractive returns for the second quarter of 10.6%. Also, it continues to act as a natural hedge against rising interest rate and basis risk. Currently, 13% of the capital is allocated to the MSR portfolio, and the company is looking at attractive opportunities in bulk transaction and flow sale arrangements. It is also targeting new production MSRs.
Although the company's leverage is up from the previous quarters, it is still significantly lower than its peers' average. So TWO has room to increase its leverage and invest in strategic investments.
On the liability side, the company has access to FHLB funds, which offers two advantages. Firstly, they have a larger duration than repo agreements, which reduces asset liability mismatch. Secondly, it is cheaper than the repo, which reduces the overall cost of funding for the company. So, FHLB not only reduces the dependence on the repo market, but also offer key strategic benefits, as mentioned above. By the end of the second quarter, TWO had utilized all of its $1.5 billion advances with an average cost and maturity of 0.4% and 280 days, respectively.
On the earnings call, the management said they were expecting that the Fed would keep rates low, but they feared the end of the Federal stimulus program will impact the mortgage market. I completely agree with the company's first prediction that interest rates will remain low because there is still under-utilization of the labor market. The two major slacks, namely lower wage growth and lower labor force participation rate, continue to remain a concern for the labor market. Both these indicators modestly improved in the recent job report for the month of July, but I believe they are still below the Fed's target.
However, I think the end of the asset purchases will not be a serious concern for mortgage markets because the supply of MBS is expected to remain low, which means the Fed still invests a major chunk in the market. So, I believe the transition will be smooth and volatility will remain low. This is the reason I believe TWO is over-hedged and the extra hedging cost is pressuring core EPS.
Dividends and Valuation
The company's dividends are not covered by its core EPS, which dilutes its book value growth. TWO continues to offer an attractive dividend yield of 10%, and there is no imminent danger of dividend cuts because the core EPS is expected to improve in the second half of the year due to its strategic initiatives.
In the second quarter, TWO offers a 6% return on book value with a dividend and book value increase of $0.26 per share and $0.38 per share, respectively. Furthermore, I also believe that the company should not trade at a discount to its book value due to its well diversified portfolio. Also the company's hedging portfolio is structured to minimize the interest risk. But the risk is not completely hedged as it was in the first quarter, which is why I am decreasing my target price to book value ratio to 1. My price target is $11.09 (1*BVPS), which means price appreciation of 7%.
Source: Company Earnings Report
I believe that the company's strategic investments continue to paint an encouraging outlook. Furthermore, the company has reduced its reliance on the repo market through its FHLB membership. Also, TWO continues to offer an attractive total return of 17%. However, it needs to reduce its hedged positions, as the macro-economic environment is stable with low interest rate volatility.
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