Two Harbors: Disaster

| About: Two Harbors (TWO)


I have gone on record as having immediate concern over the dividend last year.

With quarter-after-quarter of poor core earnings and an expensive buyback the risk is even more real.

I predicted a better Q4 for companies in the mREIT sector and with earnings just released I discuss the results and key metrics.

Two Harbors Investment (NYSE:TWO) is a name that I have gone on record as having immediate concern over the dividend. I called for a dividend cut during the previous quarter, but I was wrong. Shockingly the dividend was maintained and I came out and said I was wrong. But you know what? I think I am being too hard on myself. I was factually incorrect as history shows, but my motivations were correct. And while I was wrong, I am here today reiterating my substantial concerns. Get out of the name. It's going lower and this dividend will be cut. It's not a matter of if. It's when. I was too early in my warnings, but had you sold your principal would have been safe. I mean since I started sounding the alarm in August the stock has fallen 15%. When I first questioned the dividend safety in May, the earnings picture was stronger than the rest of 2015. While there are issues with the mortgage servicing rights, many have stayed in the name and it has initiated a very strong buyback. But just how is the company performing?

Look, I recognize that long-term investors may be picking up shares and forgetting about them until 2030. I have contended there are better names in the battered sector. Be that as it may, as I have documented concerns with the company and its dividend, it is prudent to review the company. Well TWO just reported its fourth quarter earnings. Following a weak Q1 2015, a terrible Q2 2015, and another gut check in Q3, here in Q4 it was another disaster….. So far, the sector has seen better reports in Q4 than in Q3 and Q2. But the pattern has been that everyone is getting hit, though some less hard than in Q3. Only a few of the best names are stable and covering dividends. But TWO has been an issue with me for some time. The present report, shows continued weakness and indicates to me that there is nothing about this report that makes it stand apart from the competition as a buy. Remember I had predicted that this quarter would see a lower constant prepayment rate, which should boost the underlying key metrics of the company as well as earnings.

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Speaking of earnings, the company saw a comprehensive loss of $3.2 million or $0.01 per share. This is better than the Q3 loss of $0.25, but this doesn't tell us about dividend coverage. The best gauge for dividend coverage is, of course, the core earnings. Well, these missed my own expectations by $0.02. I was looking for $0.22, that is stable earnings from Q3. As it turns out, they came in at $72.1 million or just $0.20 per share. Not good. Why not? Well this is down from Q3 2014's $79.4 million, or $0.22 per share. It is also down from Q1, which saw $0.24 per share and down from the bad Q2 which saw $0.22 per share. This, of course, is a key gauge of the company's ability to pay dividends. Well, at $0.20 the dividend of $0.26 is again not being covered by core earnings. How many times can the company fall short and maintain the payout? This makes me feel as though it will be cut. The company only has so much in reserves and can only use the return of capital approach and/or let book value suffer for so long. Let's not forget the buyback requires capital. The cut is coming.

What about the key metrics I look for in an mREIT? Well, the company's book value per share, after taking into account the dividend of $0.26 per share, was $10.11, dropping from $10.30 as of September 30, 2015 and is down from the $10.81 as of June 30, 2015 and down from the $11.08 as of March 31, 2015. Now don't get me wrong book values have been hit in most of the mREITs. The book value fell in line with competitors and in line with what I expected. Looking to economic return (that is loss in book value plus dividends), the company saw just a 0.7% return.

What about the building blocks of the net interest rate spread? Well, the annualized yield on the company's portfolio assets was up nicely to 4.56% from 4.14% in Q3. That is excellent. The annualized cost of funds fell 5 basis points to 1.30%. I have to say I am very pleased. Taking the difference of these two variables results in a net interest rate spread that slightly improved to 3.26% from 2.83% last quarter. It is now back on par with its historic mid 3% range. Still, that was just one piece of positive news in an otherwise bleak quarter.

One of the key strengths to this company has always been its low constant prepayment rate. In fact, it has always boasted a below industry average constant prepayment rate. But it had been on the rise in 2015. It has, in line with my predictions, pulled back since hitting its highest levels that I can remember back in Q3. Just look at the trajectory. In Q4 2014, it was 7.5% and in Q1 2015 it rose to 8.2%. Thanks to continued refinancing activity, it rose to 9.0% in Q2 2015. This pressure continued in Q3 as it jumped to 9.7%. But here in Q4 I was very disappointed to see it jump to 10.3%. This is moving heavily in the wrong direction. I was surprised it did not pressure the spread more, but the company does have diversified holdings which help give it a boost. Still, prepayments are a kiss of death in this sector. Even with a buyback, the results clearly show the dividend failing to be covered once again. Let's not forget, that buyback takes money that can be used for dividends. The risk of a cut is exceptional.

All things considered, Two Harbors as a whole is running in the middle of the pack of mREITs. It's not performing appreciably worse, or better, than its competition. I was surprised about the constant prepayment rate rising especially considering the one highlight of the quarter, a drastically improved spread. Generally a rising constant prepayment rate crushed the spread, but the company made some strong portfolio moves in the last two quarters and is well balanced, which help boost the yield on holdings. Still this quarter was another disappointment. The name has been in a downtrend as far as key metrics go for several quarters now. I may have been early (or even wrong last summer) but I repeat the dividend is going to be cut. I expect a cut to the $0.22 level is coming. As such, I am still not a buyer here even with the stock trading at 23% discount to-book.

Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles, which are time sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.