Capstead Mortgage: 11.5% Yielding mREIT's Net Interest Income Is Declining

| About: Capstead Mortgage (CMO)

Capstead Mortgage (NYSE:CMO) announced its performance for the third quarter of October 24, 2012, with an earnings figure of $0.35 per diluted common share against consensus mean expectations of $0.38 per share, giving analysts a negative surprise of 8%. The company reported net interest income of $43.5 million. The following table gives a snapshot of the results of the third quarter of the current year. Going forward, we believe the company will be adversely impacted by the third round of easing being carried out by the Fed, with a decline in asset yields and the resultant decline in net interest margin. However, the impact will not be as significant, as most of the securities that the company owns are adjustable rate securities.

The company reported interest income of $63.6 million, 1% above the revenues of the same quarter of the previous year. The surge was despite a sequential decline of 18 basis points in the net interest margin that the company earned during the third quarter. During the third quarter of the current year, the company earned 1.3% interest above its cost of funds. The improvement in net interest income was primarily due to a 17% surge in the interest earnings assets during the third quarter. Asset yields were negatively affected by the acceleration in amortization of securities purchased at premium.

The company seemed not to have benefited from the ultra low interest rate environment, as the cost of its funds increased 2 basis points from the linked quarter to 0.56% during the third quarter of the current year. Interest expense of $20 million, when compared to the same quarter of the previous year, surged 12%.

During the third quarter, the company was able to curtail its operating expense, which led to an 11% decline YoY. This was a result of compensation-related expenses, which are linked to increases or decreases in the company's earnings.

Overall, the bottom line of $40 million declined 2% when compared to the same quarter of the previous year.

The conditional prepayment rate at the end of the third quarter increased from 15.9% to 18.7% at the end of the third quarter. This, however, is still below Hatteras Financial's (NYSE:HTS) most recent conditional prepayment rate of 20.5%. Like Hatteras Financials, Capstead also moderately decreased its leverage ratio from 8.05 times to 7.96 times.


The company was forced to cut its quarterly dividends by 10% from $0.4 to $0.36. The stock currently offers a dividend yield of 11.5%, which is well backed by an operating cash flow yield of 18.7%. The cash dividend coverage ratio comes out to be 1.18 times. This reflects the fact that the company has enough financial muscle to continue this dividend distribution. However, if the Fed accelerates its bond buying, the company's net interest income will be hurt a little.


The stock trades at a 6% moderate discount to its book value, as compared to a 10% discount for Hatteras Financials. Both have similar market caps and both invest largely in agency adjustable rate securities. As opposed to this, the largely followed American Capital Agency (NASDAQ:AGNC) and Annaly Capital (NYSE:NLY) trade at 10% premium and a moderate 2% discount to their respective book values.

In conclusion, the results were negatively affected by QE3, despite the fact that most of the mortgage backed securities that the company owns are adjustable rate in nature. The yields were affected by acceleration in prepayments, and the resultant increase in amortization costs for the securities purchased at premiums. Going forward, we believe the company's interest income will get hurt, if the Fed decides to accelerate its bond buying program. Therefore, we recommend investors to hold the stock and long mortgage REITs that have significant holdings in non-agency mortgage-backed securities.

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.

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