CYS Investments (NYSE:CYS) is an mREIT I have long followed and have really been a fan of the fact that it manages a semi-diversified portfolio that invests in various types of agency mortgage-backed securities. It has some diversification into commercial mortgage loans and other commercial real estate debt, commercial mortgage-backed securities, and other commercial real estate-related assets. After being asked about the name I decided to revisit the performance of this once strong name that fell from grace, but began to turn things around this year. It has just reported earnings and I want to examine the results to understand where the bar has been set.
Let us get right into the earnings and key metrics we look for in mortgage real estate investment trusts. Let me say that the company beat earnings expectations that I had. I was looking for $0.25 per share in core plus drop income; more on this in a moment. Further net interest income rose year-over-year. The company saw $52.2 million in net interest income for Q3 2016. This surpassed the consensus analyst expectations by $3.88 million and my personal expectation of $50 million. Two good signs.
What we care about, of course, is not net income, but core income. It's a better measure of the ability to cover the dividend. Remember the dividend has been cut. Several times. It was one of the reasons I turned sour on the name; it was having difficulty earning its dividend. Stronger, best-of-breed names have been outearning their dividends. Core earnings plus drop income came in at $39.1 million, or $0.26 per share. While surpassing my expectation let us be clear that this is still down substantially from core income a year ago. It is also important to note that we see that this was made up of core earnings of $28.6 million, or $0.19 per share. Thus, drop income was $10.5 million, or $0.07 per share.
Now when it comes right down to the 'nitty-gritty,' the key metrics I harp on played a big role in these earnings figures. First, total interest income decreased to $69.7 million. Total interest income has been on the decline for two years plus. The reason this fell was because of lower average settled debt securities. What is most relevant is that performance was an increase that I predicted. I had stated that prepayments would subside into the end of the year in 2015 and early 2016, then ramp up to close out the year. Here in Q3, the constant prepayment rate jumped to 14%, up from 12.9% in Q2. It is also up significantly from the 7.6% in Q1.
I will also point out that the average cost of funds in Q1 2016 fell to 0.68% compared to 0.72% Q2 2016. This decline is welcome however it was not as impactful due to the yields falling at a greater pace. But you do the math. A higher yield on investments needs to outpace the increase in cost of funds to benefit the spread. In this case the decrease in yields was slightly less than the drop in cost of funds. The net interest rate spread, net of hedge including drop income, was 1.37% for Q3 2016, up 1 basis point compared to 1.36% in Q2 2016.
With the motion in rates, the value of some of the holdings were down a bit, but it was a mostly stable quarter in this regard. Net of the $0.25 dividend, book value came in at $9.79. So it is one of the first times that book value has risen significantly in some time. It was up $0.24 or 2.4% from $9.55 to start the quarter. This is a bit of a turn-around puts a stop, for now, to the long and slow blood-letting we have seen in book value. Of course book value is still down incredibly over the last few years.
Look compared to recent history, this quarter was decent. The year has been once where the company finally put a stop to the long decline. Has it bottomed out? I think there is more pain ahead when rates increase, at least in the short-term, but longer-term things look stronger. Even though it covered its dividend and saw some improvements, it's nothing to write home about. Simple as that. As I have said all eyes should be on the constant prepayment rate. Under $8.00, I think the name is worth considering, but use caution.
As always, I welcome your comments.
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.