Two Harbors Investment's New 12% Dividend Yield Is Sustainable

| About: Two Harbors (TWO)

Even with the recent dividend cut, Two Harbors Investment (NYSE:TWO) has a high dividend yield of 12%, which is above the prevailing 10-year treasury yield, and is in line with its peers' dividend distributions. The analysis below reveals that the company generates enough operating cash to sustain the new dividend rate, which is why investors can expect the new dividend distribution to continue in the foreseeable future. Given the current scenario of record low interest rates, TWO is an attractive investment opportunity. Therefore, we reiterate our buy rating on the stock. Despite cutting the dividends, the stock is still trading up today.

TWO is one of the mid-cap mortgage REITs in the U.S. with a high dividend yield. On September 12, 2012, the company cut its quarterly dividends when it made an announcement for the third quarter dividend of $0.36 per common share. It has been paying $0.4 per share in quarterly dividends since December 2010. In the remainder of this report, we will try to look at the reasons for such a dividend cut, and whether the announced dividend could be sustained in the coming quarters.

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The table given above shows that during the first half of the current year, the company did not generate enough cash to pay for dividend distributions. The cash dividend coverage ratio remained at 0.64 times and 0.57 times in the first quarter and the second quarter of the current year. The company earned $24 million during the second quarter, while earnings for the first quarter were $51.8 million. It clearly shows that the company did not have the required earnings, and it also failed to generate enough cash from operating activities to pay dividends.

Over the past four quarters, the company on average paid $58.7 million each quarter, while it generated $48.5 million in operating cash flows. The average cash dividend coverage ratio for the past four quarters comes out to be 0.82 times, suggesting that the company did not have enough cash to support dividends. Therefore, a dividend cut was evident. With the new quarterly dividend, the dividend yield comes out to be 12%. This double-digit dividend yield is still significantly higher than the prevailing 1-year treasury yield. Two Harbors' dividend yield, after the dividend cut, was still comparable with many of its peers, including American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY), which offer a dividend yield of 13.9% and 12.5%. American Capital Agency and Annaly Capital Management are the two large cap largely-followed mortgage REITs.

With the new quarterly dividend announced at $0.36 per share and 140.6 million shares outstanding, the company will need $50.5 in operating cash flows every quarter to sustain the new lower dividend distributions. The table given above shows that on average, the company generated $48.5 million during each of the past four quarters. This means that investors can expect this dividend rate to continue in the foreseeable future.

Earlier, in a report, we concluded that the stock, which is valued at a premium, earns one of the highest interest rate spreads among the mortgage REITs being considered in our mortgage REITs portfolio. The company has a diversified assets portfolio, which includes a blend of fixed, adjustable-rate securities, and non-agency and agency mortgage backed securities. It also has an alternative investment strategy, through which it acquires properties, especially foreclosed homes, which are later rented out to generate rental income. This diverse nature of the company's business and its assets portfolio makes the company a favorable investment.


The stock trades at a premium of 20% to its book value, as compared to 8%, 9% and 22% premiums for MFA Financials (NYSE:MFA), Annaly Capital Management and American Capital Agency.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Financials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.