Ellington Residential: Say It Isn't So

| About: Ellington Residential (EARN)

Summary

Q4 earnings are out and they surprisingly bucked the sector trend.

I discuss the critical metrics.

The dividend must be safe as it has been covered every single quarter with ease.

Watch the prepayments and it's likely time for a portfolio rebalancing by management.

Ellington Residential Mortgage REIT (NYSE:EARN) is a name that I have argued that you need to know about. But I was surprised when the company cut its dividend 18% to $0.45 quarterly. This one really caught me by surprise. In the end, I surmised it was a preemptive move that meant the company was running into trouble for the latter half of 2015. Indeed, its Q3 was a bit weak. But I stated that the company was paying a 14% yield and I trusted the dividend coverage going forward. Of course, the sector took another nose dive to close 2015, though it has recently had some wind in its sails. Many of the companies that have reported their fourth quarters have showed a turnaround for the quarter following dismal Q2 and Q3 reports. EARN is now out with its fourth-quarter report. So how did EARN do? To answer this question, we will review the key metrics that I look for in an mREIT (table 1).

Table 1. Key Metrics of Ellington Residential Mortgage REIT

Key Metric

Most Recent Data*

Q4 2015 book value and % change from Q3 2015

$15.86 (-2.1%)

Net interest rate spread in Q4 2015

1.67%

Dividend (yield)

$0.45 (15.4%)

Q4 Net income per share

$0.11

Q4 Core income per share

$0.49

Dividend covered?

Yes

52-week share price range

$9.57-$16.99

Click to enlarge

Source: Ellington Residential Mortgage REIT's Q4 Results

*as of 12/31/15

Earnings

The company made money on a GAAP basis. It reported net income of $1.0 million or $0.11 compared to a loss of $4.8 million or $0.53 per common share last quarter. However, a better measure of the ability of the company to pay its dividend is its core earnings. Core earnings were $4.5 million or $0.49, falling significantly from the $6.3 million or $0.69 in core earnings last quarter. It also is the lowest the company made all year. Recall that in Q2, core earnings were $5.2 million or $0.57 per share and were $6.0 million or $0.66 per share in the first quarter. What's the most important thing to note here is that the dividend of $0.45 was indeed covered by core income. This raises a point related to my surprise over the dividend cut last year. These results suggest that the dividend cut was preemptive, as this quarter was the weakest all year. This is interesting because the company has consistently seen year-to-date core earnings per share more than cover the dividends paid since I have been covering it. Say it isn't so! The company bucked the trend of this sector, suggesting to me that management may need to consider rebalancing the portfolio into more favorable assets. It simply underperformed the sector.

Funds from operations

As I have said many times, I believe it also can be helpful to examine a company's funds from operations. Well, EARN's most recent available funds from operations shows that although the funds from operations have declined slightly quarter over quarter, it has had very stable numbers here. Further, funds from operations have been relatively stable year to year. The most recent data shows funds from operations coming in at a positive $9.79 million, easily covering the $4.1 million in dividends paid.

Book value

As I seem to always remind readers, book value is the strongest predictor of an mREIT's share price. When examining an mREIT, we need to know what we are paying relative to what the company's assets are roughly worth. Book value has been falling over the last few quarters, just like most names in the sector. At the end of Q3, book value was $16.20. To end Q4, it was $15.86, dropping $0.34 or 2%. The rate at which the book value fell slowed (compared to a 5% drop in Q3), but this decline continues the bleeding the name has experienced. So, of course, the stock has been on sale (discount-to-book), but this simply means the Street was correctly pricing in this continued decline. The discount is sizable now. The stock currently is trading at $11.77 and the discount-to-book has expanded. At the end of Q3, the discount was 21%. Now the stock trades at a $4.09 or 26% discount. Book value continues to suffer and I don't find this discount attractive because other key metrics are moving in the wrong direction.

Net interest rate spread

Now there's a reason earnings were down. They were down because the key metrics weakened. The net interest rate spread is a good measure for earnings potential. The spread got crushed due to its building blocks moving with volatility. EARN saw its average asset yield on its investment portfolio come in at 2.84%, falling a whopping 56 basis points from the 3.40% from the third quarter. EARN's average cost of funds fell slightly during the quarter. It came in at 1.17% vs. 1.21% in Q3. Since the yields fell more than that cost of funds, the company saw its net interest rate spread narrow significantly. The average net interest rate spread was 1.67% compared to 2.19% for the third quarter. Ouch. This is a major reason core income was down. This was interesting because many companies have seen either a flat spread or a spread that widened in Q4, in large part because of a constant prepayment rate that declined.

Constant prepayment rate

The constant prepayment rate has become my most watched indicator. It had been rising for many mREITs over the last year, but I had been on record that I expected prepayments to subside for most mREITs in Q4. Many mREITs saw a stronger Q4 than Q3 because of an improving constant prepayment rate. However, EARN saw its constant prepayment rate increase in Q4. But I have to tell you, I was surprised at the impact the rise in prepayments had on the company's yields/income. This is because all things considered, the company has a very low constant prepayment rate. In fact, it is much lower than the sector as a whole. The weighted average prepayment rate was 7.5% for the fourth quarter, up from 7.1% last quarter. This is the highest prepayment rate I have seen for the company since I started covering it.

Conclusion

I have long thought EARN to be a superior mREIT over many others. But this quarter has shaken my resolve. If it wasn't for the substantial discount and the fact that the dividend is being easily covered, I would have you avoid the name. Still, I think the performance reflects the underlying portfolio holdings. Going forward, I would like to see some changes to the holdings and management has indicated it will be doing just this in 2016, getting into more non-Agency RMBS. Despite the bleeding in book value, the name is strong for income and the dividend remains secure. As such, I maintain a soft buy rating on the stock.

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.