MFA Financials (MFA), like most other mREITs, has enjoyed the prevailing record low interest rate environment for some time. However, now that the interest rate yield curve is beginning to flatten, MFA's interest rate spread is beginning to depress. This is also the primary reason why its earnings for the second quarter missed analyst estimates. Having said that, we believe the depression in the interest rate spread is not enough to threaten the 11.5% sustainable dividend yield. Supporting our belief of an upside potential in the stock, which is trading at cheap multiples, are the facts that increased institutional and insider buying have been witnessed. We believe that a significant portion of adjustable rate and hybrid mortgage securities enable the company to overcome most of the headwinds that it faces, which makes us bullish on the stock.
MFA Financials is organized to operate as a REIT in the U.S. financial sector, and it aims to invest in both agency and non-agency mortgage backed securities (MBS), with a majority (approximately 62%) of the portfolio invested in agency MBS. The company has a strategy to invest at least half of its portfolio in adjustable rate mortgages (ARMs). Besides investing in fixed rate mortgages, the company also invests in hybrid securities. The blend of agency and non-agency securities enables the company to earn attractive returns with less sensitivity to changes in the interest rate yield curve and prepayments. However, the addition of non-agency securities to the portfolio increases the risk of default. Unlike agency MBS, yields on non-agency MBS are sensitive to changes in credit performance.
Like other mortgage REITs, MFA Financials, by borrowing short-term, has continued to enjoy the low interest rate environment for some time now. However, after the Fed's Operation Twist and its maturity extension program, the interest rate spreads for mREITs are now getting narrower due to the flattening of the interest rate yield curve; cutting profits by squeezing the interest income for MFA Financials and other mortgage REITs. Changes in interest rates and the yield curve also affect the book value of the company. Experts are anticipating a minor decline in interest rates. The reported sensitivity of the company's interest income and portfolio value, to a 50bps decline in interest rates, is an increase of 0.76% and 0.16%, respectively.
Record low mortgage rates have pushed up prepayments. These accelerated prepayments increase the cost of amortization on securities purchased above par value. The government-sponsored Home Affordable Refinance Program, which allows underwater mortgages to be refinanced, also has the potential to further accelerate prepayments. However, since over half of MFA's asset portfolio is composed of adjustable rate mortgage securities, which adjust to the prevailing rates, the company has less exposure to prepayments as compared to mREITs with larger proportion of fixed rate mortgage securities.
To fund its assets portfolio, the company uses short-term borrowing. These short-term repurchase agreements expose the company to counter party risk. To mitigate this risk, the company has increased the number of its borrowers to 25. The company also has some repurchase counterparties in Europe, thus exposing it to the debt stricken European markets. The exposure, as a percentage of MFA's total assets, is 7.6%. MFA's financing activities could significantly be affected by a prolonged European debt crisis.
Second Quarter Performance Review
The table below provides the details of MFA's earnings and revenue surprises. The company has a history of missing analyst consensus estimates for both its top and bottom line. On average, over the past eight quarters, the company has missed EPS estimates by 2.6%, while it missed revenues estimates by 5.9%. The trend continued this time around when the company reported its second quarter performance. MFA reported revenues of $82.8 million, 5.8% below estimates of $87.9 million. The reported EPS of $0.20 missed expectations of $0.22 by 9.4%.
The company reported interest income of $125.5 million for the second quarter of the current year, against $132 million in the second quarter of the previous year. The decline in interest income was largely associated to a 25% decline in interest income associated to agency MBS. The decline in interest income was partially due to a 3bps sequential decline in the yield on interest earnings assets. The general low interest rate environment and higher CPRs influenced the decline in asset yields.
Interest expense for the second quarter surged to $42.7 million, up 15% when compared to the prior year. The increase in interest expense was primarily associated to a surge in borrowing costs (repurchase agreements) and senior notes. Costs increased due to an increase in average borrowings during the quarter. Higher cost and longer maturity borrowings also helped increase costs. The cost that the company paid on its interest bearing liabilities increased 6bps during the second quarter.
The decline in asset yields earned and the surge in interest paid on its interest bearing liabilities helped the interest rate spread of 2.45% to declined 9bps, when compared to the linked quarter.
The company, as compared to most of its peers in the U.S. mortgage REITs, employs less debt in its capital structure. MFA's debt-to-equity ratio at the end of the second quarter is 3.6:1, as against 7.9:1 and 6.09:1 for American Capital Agency (AGNC) and Annaly Capital Management (NLY).
Ownership Structure and Insider Trading
Approximately 42% of the company is owned by a concentration of 10 renounced institutional investors, including Morgan Stanley Investment Management, Vanguard Group and Goldman Sachs Asset Management. Goldman Sachs (GS) holds the largest chunk (6.75%) of the entire stock of MFA Financials. Goldman Sachs Asset Management increased its holdings of MFA from 21.47 million shares in December 2011 to 24.14 million in 2012, while following the trend, the Vanguard Group increased its holdings from 14.29 million shares in 2011 to 14.62 million in 2012. This increasing trend reflects these institutional investors' confidence in MFA's business model and its management.
The list provided on Reuters, and the graph below, show the most recent insider buying by some of the senior executives, including the president of the company. This indicates that those who have more information of the company's operations believe that there is more upside potential in the stock.
Considering the prevailing record low interest rate environment that is expected to stay the same until 2014, and despite a 19.5% price appreciation since the beginning of the year, MFA Financial's stock offers one of the highest and most attractive shareholder distributions in terms of its dividend yield of 11.5%. This is in comparison to Capstead (CMO)'s 11.4%. The company has an operating cash flow yield of 11.7%, reflecting its ability to continue such dividend distributions in the foreseeable future. The inherent non-diversifiable risk in the stock, as depicted by its beta of 0.14, is relatively low when compared to most of its competitors in the U.S. mREITs Industry.
The company's stock is trading at cheap multiples when compared to most of its peers in the U.S. mortgage REITs sector. With regards to its book value multiple of 1.04 times, the stock is trading at a discount of 10% and 2% compared to American Capital Agency and Capstead Mortgage Corp . The stock is trading in line with Annaly Capital Management 's book value of 1.05 times. Historically, the stock has traded as high as 1.3 times its book value.
The company has sufficient financial strength, due to which institutional investors and insiders have increased their buying of the stock. The stock's sustainable and attractive dividend yield, along with cheap valuations, makes it a buy.