Two Harbors: Substantial Improvement Needed

| About: Two Harbors (TWO)
This article is now exclusive for PRO subscribers.

Summary

After a recent overdue dividend cut, the company has maintained the new payout for Q2.

I discuss why this dividend may still be at risk.

Improvement is needed on the earnings front.

Two Harbors Investment (NYSE:TWO) is a name I have gone on record as having immediate concern over the dividend in the past. For a long while, in fact. Finally the dividend was cut (it should have been cut sooner) a few months ago. While I recognize that long-term investors may be picking up shares and forgetting about them until 2030, there are better names in the battered sector as I have contended. However, the dividend at its newly cut level of $0.23 was once again maintained.

The company just announced it would pay a quarterly dividend of $0.23 per share of common stock for the second quarter of 2016. This dividend is payable on July 20, 2016 to common stockholders of record at the close of business on June 30, 2016. What is important to note here is that Two Harbors distributes dividends based on its current estimate of taxable earnings. Most often these closely align with core income.

When we turn to look at the performance and dividend coverage, investors should be slightly uneasy. This is because when TWO reported its Q1 earnings it showed continued weakness. The company saw a whopping comprehensive loss of $67.6 million or $0.19 per share, which is among the largest losses in company history. However, it is a GAAP number, and we care about dividend coverage. The best gauge for dividend coverage is, of course, core earnings. I was looking for $0.23, which would be just enough to cover the dividend. As it turns out, they came in at $71.8 million or just $0.21 per share.

What about the key metrics I look for in an mREIT? The annualized yield on the company's portfolio assets was up to 4.58% from 4.56% in Q4. That is positive. The annualized cost of funds fell 9 basis points to 1.21%. I have to say I am very pleased with this key metric, even though it did not translate to earnings improvement. Taking the difference of these two variables results in a net interest rate spread that slightly improved to 3.37%. The constant prepayment rate fell to 9.2% in this quarter, which helped the spread widen by improving the yield on assets.

Still, prepayments are a kiss of death in this sector. And they remain rather high for TWO. Even with the recent buybacks the company has undertaken, the results clearly show the dividend failing to be covered once again. Let's not forget that buyback takes money that can be used for dividends. The risk of another cut is still prevalent and without substantial improvement this year I think the dividend will be cut again.

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.