Two Harbors: Keep Sailing

| About: Two Harbors (TWO)


I've urged mREIT investors to sail away from TWO in the past.

Dividend coverage has been my key concern.

I discuss Q3 results and the fate of the dividend.

Two Harbors Investment (NYSE:TWO) is a name I have repeatedly had concerns over, particularly as it pertained to the dividend in the past. I've urged mREIT investors to sail away in the past. It just has not delivered relative to stronger names in the sector. For a long while, in fact, I have had concerns over the dividend payment. Finally the dividend was cut (it should have been cut sooner) earlier this year. While I recognize that long-term investors may be picking up shares and forgetting about them until 2030, there are better names in the battered sector. That said, TWO has potential. However, the dividend at its newly cut level of $0.23 has been tough to meet when we review performance. What is important to note here is that Two Harbors distributes dividends based on its current estimate of taxable earnings. Most often these closely align with core income. On that note, how is the dividend looking?

When we turn to look at the performance and dividend coverage, investors should still be cautious. The stock, if you bought it when the sector was weak earlier this year, has offered nice returns. That said, performance has not been strong. Was this the case in Q3? Well, to my surprise, TWO actually outperformed. The company swung to a comprehensive gain of $136.5 million or $0.39 per share. However, this is a GAAP number, and we care about dividend coverage. The best gauge for dividend coverage is, of course, core earnings. I was looking for $0.23, which would be just enough to cover the dividend. As it turns out, they came in at $82.5 million or at $0.24 per share. The key here is the dividend was covered and made up for last quarter's $0.01 shortfall.

What about the key metrics I look for in an mREIT? The annualized yield on the company's portfolio assets was down to 3.5%, down from 3.77% in Q2, and down from 4.5% in Q1. That hurt. The annualized cost of funds fell 10 basis points to 1.08%. I have to say I am very upset with the drop in yields though pleased with the cost of funds dropping a bit. Unfortunately, the drop in yields outweighed the drop. Despite the drop it didn't hit earnings too much, but if we take the difference of these two variables, it results in a net interest rate spread that fell from 2.59% to 2.42%. Why hit yields? A rising constant prepayment rate. In fact, the constant prepayment rate jumped to 9.7% from 8.6% in this quarter.

Prepayments are a kiss of death in this sector. We saw it with the yield. With a narrowing spread, I was surprised to see the company beat expectations. I still think there is more pressure ahead given uncertainty in rates. The headline number was a beat but this was not the strong quarter as some are saying. It was a good, positive, feel-good result. But it was so-so at best. I want the company to do well. I don't want investors losing money. But the prepayments remain rather high for TWO, though not nearly as bad as some competitors in the sector. Even with the recent buybacks the company has undertaken, the results clearly show the dividend is being barely covered. The risk of another cut is still prevalent and without sustained improvement. If we see continued improvement the dividend will remain constant. For now, it is safe, but we must keep an eye on performance and be diligent about keeping up on the company's activity.

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.