Has The Time Come For American Capital Mortgage?

| About: MTGE Investment (MTGE)

Summary

I haven't checked in with MTGE since early 2016.

Q3 results suggest the company may be turning the corner.

A look under the hood into this company.

Lower for longer.

Its been over half a year since I last checked in on American Capital Mortgage (NASDAQ:MTGE). I still remember having to say I was wrong being among the best of the best in the mREIT space. In fact, it fell apart along with the sector. After declining key metric results, pressured income and a falling book value, the dividend was cut. On top of several losing quarters in a row, this turned the tide from what I saw as a strong name to one that was weak and had been struggling all of 2015 and into 2016. While, there may be some light at the end of the tunnel, I have said the tunnel could be longer than we think. At the time shares traded at $14.60, and are now at $16.70. They are up over 33% from the low of $12.01 but still down from the $18.39 when I swallowed my pride and said I got it wrong. Is the name making a come back? To answer this question we turn to the just reported Q3 results

It reported a net gain for the quarter of $67.9 million, or $1.48 per common share. This is a nice turn around from the losing quarters I reported on 6 to 9 months ago. Of course that is a GAAP number and doesn't tell us whether the $0.40 dividend was covered. Well, the company saw $0.48 in net spread and dollar roll income. This time, the company saw a $0.02 quarter-over-quarter increase from then $0.46 in net spread and dollar roll income per common share in Q2 2016. It is important to note that these figures are excluding estimated "catch-up" premium amortization benefit. So the bottom line is that the dividend looks comfortably covered.

Book value rose as well. It came in at from $20.55 per common share as of as of September 30, 2016. This is up nicely from the $19.55 it entered 2016 with. The book value has been bleeding for years, so this turn-around is welcomed. Doing the math we still have a nice discount-to-book but that discount has narrowed. At $16.70, the stock trades at a $3.85, or an 18.7% discount-to-book. While it narrowed, the name has consistently been discounted. These discounts suggest the market is pricing in continued poor results, but I don't think there is another dividend cut coming as this is the fourth quarter in a row where the dividend was covered. However, the market does not have faith in the name as the discount is among the widest in the sector right now.

Now what about the key metrics? The constant prepayment rate has been hampering the sector as a whole. However, I did think that prepayments would rise for most companies in the back half of 2016. This was the case for American Capital Mortgage. Its constant prepayment rate rose to 13% from 11.7% in Q2 2016. This rise tends to pressure the spread and net interest income, but because yields rose and the costs of funds stayed the same, there was a widening of the spread. I was surprised to see this. The spread came in at 2.06%. Of course, the earnings as a whole are what matter at the end of the day and they were solid in this challenging environment. Gary Kain, President and Chief Investment Officer stated:

"MTGE continued its strong 2016 performance with a 7.6% economic return in the third quarter, or 30% on an annualized basis. Our net book value increased by 5.5% during the quarter, driven by spread tightening across both agency and non-agency securities. This spread tightening was most pronounced in our non-agency portfolio, in particular our credit risk transfer securities, which continued to benefit from strong housing fundamentals and conservative underwriting standards. Looking ahead, we are excited about MTGE's investment outlook given the combination of the solid housing market fundamentals within the conforming mortgage market, the improved funding outlook for agency MBS, and our view that global interest rates will remain 'lower for longer.' In addition, MTGE's expansion into healthcare real estate provides a new source of attractive investment opportunities, as well as portfolio diversification benefits. Against this backdrop, we believe our diversified portfolio is well positioned to produce attractive risk-adjusted returns."

Lower for longer. That statement is the take home. However, if rates remain low, and the fact is that the Fed wants to start moving rates higher, prepayments could spike due to refinancing activities. The dividend is safe for now and the company continues to transition its portfolio. The company survived the turmoil that began in 2013 and seems to be at its tail end now. Given the stock has rebounded off lows when I felt the name would be worth a stab given the dividend coverage, I would hold the stock here.

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 that are time sensitive. 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.

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