When it comes to Dynex Capital (NYSE:DX), analysis is a little more complicated. Establishing a solid valuation of the company positions wouldn't be too hard with a Bloomberg terminal, but for the individual investor or analyst it is materially more difficult to estimate fair values for the AAA-rated CMBS and the adjustable rate mortgages. I picked the company as a holding for my portfolio with a major reason being the internal management structure and internal ownership that create a better alignment of incentives.
A Quick Earnings Preview
Doing a thorough walk through every aspect of the business is an exceptionally long process for such a small mREIT, but there are a few areas I want to touch on quickly to give investors an idea of what I'm expecting for the earnings release.
The earnings release is expected Wednesday before the market opens, so this is coming up pretty fast. I was hoping to have time to run a full Core EPS estimate breaking things down. Instead, I'll have to content myself with demonstrating some quick and rough implications.
In estimating numbers like Core EPS, it is important to look at the hedging structure of an mREIT. The dividend of $0.24 is fairly high relative to the book value of $8.19, but the assets are primarily agency issues or carry AAA ratings. I know investors may recall the last recession where they found out AAA ratings on RMBS were useless. However, I don't believe that is the case today. I put a material amount of faith in AAA ratings on CMBS. Rents are still rising and the highest quality of the triple net lease REITs have seen share prices soar since the first day of the year. Therefore, I believe it is reasonable to say the value of the assets securing the CMBS will generally still be solid.
The following chart demonstrates hedges from the end of Q1 and the end of Q2:
The figures for June 30th show more hedges going further out on the yield curve and the weighted average pay rate moved up from 1.27% to 1.69%. The hedging ratio between EDFs and interest rate swaps started moving towards a heavier weighting for interest rate swaps as well. That is primarily the case due to the increase in longer duration swaps rather than a change in the shorter-term hedging picture. The third quarter saw a fairly material change, though:
The "remainder of 2015" category drops back down to 1.3% and the total notional balance runs around 1.3% rather than around 1.69%. This indicates that the net interest payment on swaps in the fourth quarter could be materially lower. I would love to use more definitive terms, but we don't know precisely which dates the different swap positions were in effect for the prior periods, which limits the ability to forecast 4th quarter costs from using second or third quarter costs. Since Dynex Capital provides numbers for both fixed rate payers and receivers, it would probably be possible with a bit more time to tease out more of the numbers.
What Heavy Swaps Means
The heavy position in swaps for 2016 rather than using EDFs means a larger portion of hedging costs would be expected to pass through Core EPS. That could result in Core EPS figures being weaker and they were already slightly beneath the dividend for 2016. There is a material risk for a dividend cut to be announced for 2016. Such an announcement usually causes at least a short-term drop in prices.
I'm looking for management to consider expanding the authorization to repurchase shares. Since management incentives are aligned with shareholders over the long term, the rationale thing for Dynex Capital to do is to repurchase shares and drive book value per share higher when the discount between book value and share price becomes exceptionally large.
In that sense, cutting the dividend could make sense. However, it would make the most sense for the company to announce the repurchase authorization and give that time to settle before announcing a dividend cut so it could immediately be active in catching any falling share prices.
It would be possible for Dynex Capital to keep Core EPS over $0.24 each quarter through 2016, but doing so would require either excluding hedging costs from Core EPS or unwinding current hedges (realizing the loss) and entering in new hedges at much lower rates. That would still be excluding costs from flowing through Core EPS. The other "option" is one that DX is unable to control. If the prepayment rates on adjustable rate mortgages fell significantly, it would push asset yields materially higher.
This is an interesting challenge in forecasting performance for DX. Since they are willing to actively repurchase shares, I would expect them to have a material boost to book value from buybacks. However, the last quarter may have seen some spreading between AAA bonds and treasuries which is unfavorable for book value. Either way that book value goes for the end of the fourth quarter, the huge movement in rates so far in 2016 practically invalidates the data for being more than 40 days out of date.
Potential Positive or Negative Catalyst
The biggest thing that could potentially send share prices moving up or down will come to the hedging profile. If Dynex Capital shows that they cut their hedges dramatically in the fourth quarter, it would indicate that they didn't get hammered with unreported losses through January and February. On the other hand, if they demonstrate higher levels of hedges, it would indicate that book value since the end of the fourth quarter could have been pummeled.
Important Extra Disclosure
This article is marked to indicate that I am currently long DX. Depending on what I see in their presentation, I might add to that position or sell out. My most likely course of action is to simply sit tight. The hedging positions that are revealed, buyback authorizations, and dividend announcements will all be factors that could influence my decision.
Disclosure: I am/we are long DX.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.