I won't sugar coat this. I am on record of having substantial concerns over Hatteras Financial's ability (NYSE:HTS) to pay its dividends. But I was wrong, or so I thought. This was because with a change in its strategy, I changed gears to highlight this name as a turnaround story. This was because after making these moves, the company had maintained its dividend of $0.50. But this was wrong. I was wrong. The sector continued to deteriorate and the company recently cut the payout once again, down to $0.45. The second quarter was not good at all nor was the third quarter. Hatteras has been all over the map performance wise, and now the fourth quarter earnings are out. So, with our latest data, I will discuss my outlook for the stock.
I had not been pleased with the quarterly data at all the last two reports. You may recall that when Capstead Mortgage (NYSE:CMO) reported to set the bar for Q4, I cited that I expected the sector to turn it around in general in the quarter, thanks to a declining constant prepayment rate. The CMO report showed a lower constant prepayment rate, a better net interest rate spread, improved earnings but a hit to book value. This is what I was looking for out of Hatteras in this report. Well Hatters managed to swing to a comprehensive gain. Last quarter, it lost registered a loss of $84.9 million. Here in the Q4 report things improved to positive $0.08. I will discuss the reasons for this move.
Of course comprehensive income is a GAAP measure. Core earnings are a non-GAAP measure and are calculated as net interest margin that is adjusted for certain derivative impacts, operating expenses and dividends on preferred stock. In my opinion it is the best gauge of the earnings power of the portfolio. Well, core earnings were $0.45. This is flat quarter-over-quarter and is down from $0.50 in Q2 and down from the $0.56 per share in Q1. While I am pleased that the trend of falling core income has been halted, I was looking for $0.47 or higher. Thus, this is a disappointment. Of course, this just barely covers the dividend of $0.45. As such we have to be concerned with the dividend. Much of the rout was due to the fact that the company prepared for higher rates but also suffered a high constant prepayment rate. I will discuss the key metrics.
I expected Q4 book value erosion for most mREITs. It is important to note that Hatteras had a stagnant book value for much of 2014 and held steady from Q4 2014 into Q1 2015 as book value as of March 31, 2015 was $22.05. But over the last few quarters this has changed, flushing my turnaround story call with it. In 2015, the declines were remarkable. Book value got crushed and came in at $21.06 during Q2. In Q3, book value was hit hard, dropping to $19.69. Now, the bleeding continued in Q4, with book value dropping to $19.38. Going into the book value calculation (net of dividends) was $25.36 of common equity, $7.01 of retained losses, $1.02 of unrealized gains on agency securities including TBA securities, and $0.01 of unrealized losses on interest rate swaps. So what about the discount-to-book? At the time of this writing, shares trade at $13.03, up 4% today alone. This translates to a $6.35 discount, or 32% discount-to-book. This is of course still one of the largest trading differentials in the sector. That said, I am not a buyer because I'm worried about the dividend.
Net interest rate spread
When I saw the earnings measures I thought that the spread would see a boost driving the earnings. The yield on the company's mortgage backed securities jumped 20 basis points to 1.97% quarter-over-quarter. At the same time the company's cost of funds drop quarter-over-quarter to 0.55%. Calculating the math, we see that the spread widened nicely. Hatteras saw a net interest spread of 1.42% in Q4 2015 compared to 1.19% for Q3 2015. This not a huge drop but was a drop nonetheless. It led to net interest margin increasing nicely to $56.1 million from $51.7 million last year. But why the boost?
Constant prepayment rate
It all comes down to the constant prepayment rate. Now, remember I had predicted the constant prepayment rate for the whole sector would stabilize/come down in Q4. Remember that this is the rate at which the principal of the loan is expected to be prepaid in a given time period. In 2014, the rate was high for Hatteras and it was one of the weakest points associated with the stock. In Q3, it reached crisis levels. It came in at 21.1%. You see these high prepayments immediately cap some of the yield income, However, the constant prepayment rate did decline to 17.2%, driving a mostly successful quarter. Still, at these levels the prepayments are well above the sector average. You are not going to have winning quarters with these kinds of numbers.
Despite the improvements the quarter was weak. But it is all relative. It is strong compared to Q3 and Q2 2015. But go back 18 months and you will note the decline in performance in every single key metric. Now I will admit here that on paper, I like this company's asset mix, and believe they have successfully re-balanced the portfolio. That said the prepayments are simply crushing the company. If the prepayments can get back under 15%, I may find the discount-to-book more attractive. However, there has been an uptick in refinancing activity of late, so the prepayment risk is likely to persist this year. Thus, I expect further book value erosion and pressure on the ability to pay dividends in the interim.
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 that are time sensitive. 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.