Orchid Island Capital's Near-Term Dividend Sustainability And Projection Analysis (Including Current BV Projection)

| About: Orchid Island (ORC)
This article is now exclusive for PRO subscribers.

Summary

Following continued requests by readers, this article analyzes ORC’s near-term dividend sustainability by performing two tests based on recent quarterly results.

Test 1 analyzes ORC’s quarterly estimated REIT taxable income while Test 2 analyzes a metric which considers the fairly recent changes to the company’s risk management strategy.

This article also includes a brief analysis regarding two of ORC’s fixed-rate agency mREIT peers, AGNC and NLY, regarding several dividend metrics.

My projected ORC dividend per share rate for December 2016 and January 2017 is stated in the “Conclusions Drawn” section of the article.

My buy, sell, or hold recommendation, current BV projection (BV as of 12/7/2016), and current price target for ORC is in the “Conclusions Drawn” section of the article.

Author's Note: This article provides a detailed analysis with supporting documentation on the "most probable" dividend per share rate Orchid Island Capital Inc. (NYSE:ORC) will declare for December 2016 and January 2017. I have performed this detailed analysis for readers who requested such an analysis be provided at periodic intervals. For readers who just want the summarized conclusions/results, I would suggest to scroll down to the "Conclusions Drawn" section near the bottom of the article.

Focus of Article:

The focus of this article is to provide a detailed analysis with supporting documentation (via two tests) on the "near-term" dividend sustainability of ORC, including a dividend per share rate projection for December 2016 and January 2017. I am writing this particular article due to the continued requests that such an analysis be specifically performed on ORC, especially in light of recent quarterly earnings and events. Understanding the tax and dividend payout characteristics of ORC will provide investors with an overall better understanding of the mortgage real estate investment trust (mREIT) sector as a whole.

Due to the fact ORC has produced an annual dividend yield of at least 11.5% since the company's initial public offering ("IPO") in 2013 (and more recently above 15%), many investors have chosen this stock (including other stocks within the mREIT sector) for income-producing equity investments. From reading this article, investors will better understand how a qualified real estate investment trust ("REIT") per the Internal Revenue Code ("IRC") comes up with an entity's current dividend per share rate and specific signs when an impending increase or decrease should be implemented.

I will be performing two dividend sustainability tests within this article. These two tests will be termed "TEST 1" and "TEST 2." This will also include a brief analysis regarding two of ORC's fixed-rate agency mREIT peers, AGNC Investment Corp. (NASDAQ:AGNC) and Annaly Capital Management, Inc. (NYSE:NLY) regarding the same general topic of discussion.

At the end of this article, there will be a conclusion regarding my personal projection of what I believe ORC's dividend per share rate will be for December 2016 and January 2017. I will also include my BUY, SELL, or HOLD recommendation, projected CURRENT book value ("BV") (BV as of 12/7/2016), and current price target.

Estimated REIT Taxable Income ("ERTI") Overview:

Before we begin ORC's dividend sustainability and projection analysis, let us briefly get accustomed to the information provided in Table 1 below. ORC does not provide a table that is comparable to Table 1 below. In fact, ORC provides fairly little information in regards to IRC metrics. This was one of the main reasons why I decided to provide readers this near-term dividend sustainability analysis. Table 1 below shows ORC's ERTI from the third quarter of 2016 going back to the fourth quarter of 2015. All figures within Table 1 are for the "three months ended" (quarterly) time frame.

Table 1 - ORC Quarterly ERTI Analysis

(Source: Table created entirely by myself, partially using ORC data obtained from the SEC's EDGAR Database)

The quarterly net income (loss) figures shown in Table 1 above are derived from ORC's income statement (technically speaking, the company's "statement of operations"; see red reference "A"). In order for ORC to come up with a proper ERTI figure, there are specific "Generally Accepted Accounting Principles" ("GAAP") to IRC adjustments (reversals) that need to be performed each quarter. Income and expense recognition of certain accounting transactions differ between GAAP and the IRC (book versus tax accounting treatments; see red reference "B"). Also, one needs to be mindful of any capital loss carryforward balances that may have arisen from prior tax years.

After accounting for ORC's book versus tax reversals from net income (loss), one can now calculate the company's ERTI amount (see red reference "C"). Once this is complete, since ORC currently does not have any preferred stock outstanding (see red reference "D"), the company's ERTI for common shareholders figure is known (see red reference "E").

Due to the specific IRC provision stating an entity must distribute at least 90% of its annual REIT taxable income ("AREITTI") to retain the company's qualified REIT status, quarterly ERTI (and other similar metrics) is an important indicator regarding minimum annual distribution requirements ("ADR").

Now let us perform ORC's near-term dividend sustainability and projection analysis. This analysis will be a good general indicator of ORC's current dividend sustainability over the foreseeable future (next several months) including whether an impending dividend increase or decrease could eventually come to fruition.

Side Note: Some mREIT peers typically utilize "to-be-announced" ("TBA") "mortgage-backed securities" ("MBS") as a material part of a company's investment strategy. Companies who utilize TBA contracts agree to buy, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. Companies enter into TBA contracts with a long position as an off-balance sheet means of investing in and financing MBS.

Companies can also enter into TBA contracts with a (short) position where management agrees to sell, for future delivery, MBS with certain predetermined prices, face amounts, issuers, coupons, and stated maturities. Even though ORC does utilize TBA MBS contracts during most quarters, the notional amount of these positions are usually small. As such, ORC continues to generate very little "drop income/loss" which is also known as "net dollar roll" ("NDR") income/loss.

As such, I have determined I am excluding this specific metric within ORC's dividend sustainability analysis. Technically speaking, NDR income/loss is not a component of quarterly ERTI and is accounted for as an increase/decrease to an entity's cost basis per the IRC. Since both AGNC and NLY heavily utilized the forward TBA market during the past several quarters, each company's quarterly ERTI and NDR income figures will be discussed later in the article.

TEST 1 - Quarterly ERTI Versus Quarterly Distributions Analysis:

Before we begin TEST 1 of ORC's near-term dividend sustainability and projection analysis, let us first briefly get accustomed to the information provided in Table 2 below. Table 2 is an extension of the information provided in Table 1 above. Table 2 below shows ORC's ERTI from the third quarter of 2016 going back to the fourth quarter of 2015. All figures within Table 2 below have a quarterly time frame. Table 2 compares ORC's ERTI to the company's dividend distributions showing the quarterly underpayment (overpayment).

Table 2 - ORC Quarterly ERTI Versus Quarterly Distributions Analysis (TEST 1)

(Source: Table created entirely by myself, partially using ORC data obtained from the SEC's EDGAR Database [link provided below Table 1])

TEST 1 - Analysis and Results:

Using Table 2 above as a reference, I take ORC's quarterly "ERTI - common shareholders" figure (see red reference "E") and subtract this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "I"). If ORC's red reference "E" is greater than the company's red reference "I," then ORC technically has enough quarterly ERTI to pay out the company's dividend distributions for a particular quarter. As such, any excess quarterly ERTI left over (after accounting for the dividend distributions) would be added to ORC's cumulative "undistributed taxable income" ("UTI") balance.

If ORC's red reference "E" is less than the company's red reference "I," then ORC has currently overpaid the company's quarterly dividend distributions and must use a portion of the remaining cumulative UTI balance (or add to the deficit balance) to help pay for the overpayment.

Still using Table 2 as a reference, ORC had ERTI of $11.3 million for the fourth quarter of 2015. In comparison, ORC had dividend distributions of ($9.2) million for the fourth quarter of 2015. When calculated, ORC had an underpayment of ERTI of $2.1 million for the fourth quarter of 2015 (see red reference "J"). This calculates to a quarterly dividend distributions payout ratio of 81% (see red reference "(I / E)"). As such, I believe it can be determined ORC modestly underpaid its ERTI during the fourth quarter of 2015. Now let us take a look at what occurred during the first three quarters of 2016.

ORC had ERTI of $11.4, $9.2, and $10.0 million for the first, second, and third quarters of 2016, respectively. In comparison, ORC had dividend distributions of ($9.2), ($9.3), and ($10.4) million for the first, second, and third quarters of 2016, respectively. When calculated, ORC had an underpayment (overpayment) of ERTI of $2.3, less than ($0.1), and ($0.5) million for the first, second, and third quarters of 2016, respectively.

This calculates to a quarterly dividend distributions payout ratio of 80%, 100%, and 105%, respectively. As such, I believe it can be determined ORC modestly (some could argue materially) underpaid the company's ERTI during the first quarter of 2016, basically matched ERTI with dividend distributions during the second quarter of 2016, and slightly overpaid its ERTI during the third quarter of 2016.

ORC went from having a modest underpayment of ERTI to a slight overpayment of ERTI because the company witnessed a modest increase in repayments/prepayments regarding its MBS portfolio during the second and third quarters of 2016. As such, this increased the company's "premium lost due to paydowns" figure, which is the equivalent to GAAP's premium amortization expense.

In my opinion, considering TEST 1 on a "standalone basis," this evidence helps support ORC's stable dividend from July 2015-September 2016. With that being said, TEST 1 does not specifically account for a fairly recent change in ORC's risk management strategy. Since TEST 1 does not specifically account for this change, it would only be prudent to now perform TEST 2 and see if similar results can be obtained.

TEST 2 - ERTI Less Periodic Settlements of Interest and Current Portion of the Deferred Loss on Derivatives Versus Quarterly Distributions Analysis:

When ORC reported results for the fourth quarter of 2015, management disclosed to the public some strategic changes within the company's derivatives portfolio during February 2016. I believe one notable change should be discussed since this event impacts "taxable income" ("TI"). The following quote is from ORC's earnings press release for the fourth quarter of 2015:

"… We have also altered the composition of our funding hedges so far in the first quarter of 2016. We have closed out $700 million of the $900 million of Eurodollar shorts in place at year end and replaced them with $600 million of 4 year, pay fixed swaps with a weighted average rate of 1.025%…"

With the above quote as evidence, ORC mostly "abandoned" the company's Eurodollar futures position during February 2016 and switched over to interest rate payer swaps. Since interest rate payer swaps (as a whole) had a less severe decrease in valuations when compared to Eurodollar futures contracts during the first quarter of 2016, I believe ORC made the correct move from a valuation standpoint. However, this strategic change has two notable impacts on TI.

First, since ORC terminated most of the company's net (short) Eurodollar futures contracts, this is considered a "realizable" event per the IRC. In the past, all unrealized losses on the net (short) Eurodollar future contracts continued to be reversed out of quarterly ERTI since a realized event had yet to occur. These cumulative net unrealized losses were a sizable balance at the time of termination in February 2016 (proportionately speaking).

Per the IRC, this cumulative net unrealized loss becomes a realized "deferred" loss recognized over the remaining term of each respective futures contract (similar to a swaption). When this event was first discussed in prior articles, I stated I "preferred" the deferment of such losses (versus one lump sum loss). As such, I was pleased the company has chosen to defer such losses over the remaining term of each respective futures contract. These deferred losses will be recognized over the next several years thus decreasing TI in gradual increments.

Second, now that ORC has begun to have periodic settlements of interest from the company's interest rate payer swaps, this currently decreases TI due to the fact LIBOR remains less than the weighted average fixed pay rate of the interest rate swaps. Again, with Eurodollar futures contracts, a realized gain (loss) occurs upon the termination/settlement/maturity of the contract whereas interest rate payer swaps have periodic settlements of interest (usually reported quarterly).

With that being said, I believe ORC was able to create an interest rate payer swaps portfolio with a very attractive weighted average fixed pay rate. The current net pay rate on ORC's interest rate payer swaps is an expense of approximately 10-20 basis points ("bps"). In my professional opinion, this is currently an attractive net pay rate and is lower than most other mREIT peers that utilize this specific derivative instrument.

With that being said, this net pay rate will now be "flowing through" the quarterly income statement and will decrease TI to some extent. Simply put, both impacts, from a dividend sustainability perspective, are negative in nature and are considered/analyzed in TEST 2 below.

Before we begin TEST 2 of ORC's near-term dividend sustainability and projection analysis, let us first get accustomed to the information provided in Table 3 below. Table 3 shows ORC's ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives from the third quarter of 2016 going back to the fourth quarter of 2015.

All figures within Table 3 have a quarterly time frame. Table 3 compares ORC's quarterly ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives to its dividend distributions showing the quarterly underpayment (overpayment).

Table 3 - ORC Quarterly ERTI Less Periodic Settlements of Interest and Current Portion of the Deferred Loss on Derivatives Versus Quarterly Distributions Analysis (TEST 2)

(Source: Table created entirely by myself, partially using ORC data obtained from the SEC's EDGAR Database [link provided below Table 1])

TEST 2 - Analysis and Results:

Using Table 3 above as a reference, I take ORC's quarterly "ERTI less current + deferred loss on derivatives" figure (see red reference "E") and subtract this amount by the quarterly "distributions to shareholders from ERTI" figure (see red reference "I"). If ORC's red reference "E" is greater than the company's red reference "I," then ORC technically has enough quarterly ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives to pay out the company's dividend distributions for a particular quarter.

If ORC's red reference "E" is less than the company's red reference "I," then ORC has currently overpaid the company's quarterly dividend distributions and must use a portion of the remaining cumulative UTI balance (or add to the deficit balance) to help pay for the overpayment.

Still using Table 3 as a reference, ORC had ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of $10.1 million for the fourth quarter of 2015. In comparison, ORC had dividend distributions of ($9.2) million for the fourth quarter of 2015. When calculated, ORC had an underpayment of ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of $0.9 million for the fourth quarter of 2015 (see red reference "J").

This calculates to a quarterly dividend distributions payout ratio of 91% (see red reference "(I / E)"). As such, I believe it can be determined ORC slightly underpaid its ERTI less periodic settlements of interest and current portion of the deferred loss on derivatives during the fourth quarter of 2015. Now let us take a look at what occurred during the first three quarters of 2016.

ORC had ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of $9.5, $7.0, and $7.3 million for the first, second, and third quarters of 2016, respectively. In comparison, ORC had dividend distributions of ($9.2), ($9.3), and ($10.4) million for the first, second, and third quarters of 2016, respectively.

When calculated, ORC had an underpayment (overpayment) of ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of $0.4, ($2.2), and ($3.1) million for the first, second, and third quarters of 2016, respectively. This calculates to a quarterly dividend distributions payout ratio of 96%, 132%, and 143%, respectively.

As such, I believe it can be determined ORC basically matched the company's ERTI less its periodic settlements of interest and current portion of the deferred loss on derivatives during the first quarter of 2016. However, ORC materially overpaid the company's ERTI less its periodic settlements of interest and current portion of the deferred loss on derivatives during the second and third quarters of 2016.

In fact, ORC's combined periodic settlements of interest and current portion of the deferred loss on derivatives has steadily increased over the past five quarters. I believe this should be seen as a negative trend in regards to ORC's near-term dividend sustainability. ORC needs to consider the periodic settlements of interest regarding the company's interest rate payer swaps and the current portion of its deferred loss on all terminated Eurodollar futures contracts. This will negatively impact TI over the next several years as these contracts had "staggering" maturities through 2019.

Brief Discussion of AGNC's and NLY's Dividend Metrics:

When compared to ORC, AGNC had a notably lower ERTI per common share figure for the third quarter of 2016 (when excluding the company's NDR income). AGNC had quarterly ERTI of $0.19 per common share while distributing three monthly dividends totaling $0.56 per common share. AGNC had a quarterly overpayment of ($122) million. When calculated, AGNC had a quarterly payout ratio of 294%. Again, this excludes the notion of AGNC's quarterly ERTI and NDR income.

When including the impacts of AGNC's net long TBA MBS position, the company had quarterly ERTI and NDR income of $0.35 per common share. Still, this was notably below AGNC's three monthly dividends totaling $0.56 per common share for the third quarter of 2016. AGNC had a quarterly overpayment of ERTI and NDR income of ($68) million. When calculated, AGNC had a quarterly payout ratio of 158%.

However, when considering the "true earnings power" of AGNC's entire MBS portfolio (a non-IRC metric), the company reported quarterly ERTI, NDR income, and a net capital gain (loss) of $244 million for the third quarter of 2016. When calculated, this was quarterly ERTI, NDR income, and a net capital gain of $0.74 per common share. When calculated, this was an underpayment of $59 million and a payout ratio of 76% for the third quarter of 2016.

NLY reported quarterly ERTI of $0.19 per common share and quarterly ERTI and NDR income of $0.28 per common share for the third quarter of 2016. NLY's quarterly ERTI and NDR income (loss) is also known as the company's "estimated core earnings" ("ECE"). When calculated, NLY had a quarterly ERTI and ECE dividend distributions payout ratio of 151% and 104%, respectively.

With that being said, it should also be noted management provided an additional metric in regards to NLY's dividend for the third quarter of 2016. This additional metric was "normalized core earnings" ("NCE"). When including the impacts from NLY's "catch-up" premium amortization expense, the company reported NCE of $0.29 per common share for the third quarter of 2016. This was ($0.01) per common share below NLY's dividend distributions totaling $0.30 per common share during the quarter.

Even though NLY implied this metric would continue to factor into the company's dividend per share rate, I would caution readers that a company's premium amortization expense is, in fact, a "non-cash" item. NLY's NCE metric is more of a reconciling GAAP line item since this directly impacts a company's premium amortization expense (discount accretion income) account over the estimated life of the MBS portfolio.

Still, NLY's BoD ultimately decides on the quarterly dividend per share rate. NLY's BoD may continue to utilize NCE as a dividend per share rate metric (similar notion is AGNC taking into account the company's true earnings power).

Conclusions Drawn:

To sum up all the information in this article, TEST 1 provided the following information in regards to ORC's ERTI dividend distributions payout ratio from the fourth quarter of 2015 through the third quarter of 2016:

ORC's Q4 2015, Q1 2016, Q2 2016, and Q3 2016 ERTI Dividend Distributions Payout Ratio, Respectively: 81%, 80%, 100%, and 105%

When assessing ORC's near-term dividend sustainability based solely on TEST 1, the company's higher ERTI payout during the second and third quarters of 2016 should be seen as a cautionary/negative trend.

Next, due to the fact management utilized a different risk management strategy in February 2016 (began using interest rate payer swaps and notably lowered its Eurodollar futures contracts), TEST 2 provided the following information in regards to ORC's ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives dividend distributions payout ratio from the fourth quarter of 2015 through the third quarter of 2016:

ORC's Q4 2015, Q1 2016, Q2 2016, and Q3 2016 ERTI Less Periodic Settlements of Interest and Current Portion of Deferred Loss on Derivatives Dividend Distributions Payout Ratio, Respectively: 91%, 96%, 132%, and 143%

When compared to TEST 1, TEST 2 includes the periodic settlements of interest on ORC's interest rate payer swaps and the company's current portion of the deferred loss on its terminated Eurodollar futures contracts. When assessing ORC's near-term dividend sustainability, I believe TEST 2 should be seen as a negative trend since the company will continue to record deferred losses on its terminated Eurodollar futures contracts over time and likely continue to record interest expense on its interest rate payer swaps. However, to remain non-bias, it should be noted the net expense in regards to ORC's interest rate payer swaps has recently decreased.

Similar to the results obtained in TEST 1, management reported an increase in ORC's current portion of the deferred loss on derivatives during the second and third quarters of 2016. This negative factor puts heightened pressure on ORC to maintain a monthly dividend of $0.14 per share going into 2017. However, due to the recent notable increase in mortgage interest rates/long-term U.S. Treasury yields during the fourth quarter of 2016 (through 12/7/2016), there will be an eventual decrease in CPR percentages which will likely lower ORC's premium lost due to paydowns figure to some extent. This positive catalyst/factor will likely partially offset the continued increase in ORC's current portion of the company's deferred loss on derivatives.

When considering the results from TEST 1, TEST 2, and the current/future trends within the mREIT sector as a whole, I am projecting ORC will declare the following monthly dividends:

Dividend for December 2016: $0.14 per share (Probability of 60%)

Dividend for January 2017: $0.11-$0.12 per share (Probability of 60%)

Regarding BV performance, similar to what has occurred within the entire mREIT sector (and in particular the fixed-rate agency mREIT sector), there is a very high (over 90%) probability ORC has witnessed a notable decrease in BV during the fourth quarter of 2016 (through 12/7/2016). This is due to the recent notable negative relationship between MBS pricing and derivative instrument valuations that occurred following the U.S. presidential election. I accurately highlighted this relationship, prior to all other analysts/contributors (even contradicting a few market participants), in the following "back-to-back" articles on 11/22/2016 and 11/23/2016, respectively:

Annaly Capital's BV, Dividend, And Valuation Compared To 17 mREIT Peers (Post Q3 2016 Earnings) - Part 1

AGNC Investment: MBS Pricing For First Half Of Q4 2016 (Including Analysis Of Notable BV Decrease In November)

My projected ORC CURRENT BV (BV as of 12/7/2016) range is $10.35 - $10.65 per share. This range EXCLUDES the company's upcoming dividend for December 2016 (ex-dividend date has yet to occur).

However, it should also be noted ORC's BV decrease during the fourth quarter of 2016 should be less severe when compared to most (if not all) of the company's fixed-rate agency mREIT peers. This is due to the composition of ORC's MBS and derivatives portfolios, which I have highlighted in prior PRO articles for this company.

My BUY, SELL, or HOLD Recommendation:

From the analysis provided above, including additional factors not analyzed within this article, I currently rate ORC as a SELL when I believe the company's stock price is trading at less than a (5.0%) discount to the mean of my projected CURRENT BV range (BV as of 12/7/2016), a HOLD when trading at or greater than a (5.0%) but less than a (12.5%) discount to the mean of my projected CURRENT BV range, and a BUY when trading at or greater than a (12.5%) discount to the mean of my projected CURRENT BV range. These percentage ranges are a slight improvement when compared to my last ORC article (approximately four months ago) due to the company's more favorable MBS and derivatives portfolios, when compared to its fixed-rate agency mREIT peers, during a rising interest rate environment.

Even with the slight improvement in percentage ranges listed above, I currently rate ORC as a SELL since the stock is trading at or less than a (5.0%) discount to the mean of my projected CURRENT BV range ($10.50 per share). My current price target for ORC is approximately $10.00 per share. This is currently the price where my SELL recommendation would change to a HOLD. This price target is a ($0.25) per share decrease when compared to my last ORC article. Currently, the price where my recommendation would change to a BUY is approximately $9.20 per share. This price is also a ($0.25) per share decrease when compared to my last ORC article.

Along with the data presented within this article, this recommendation considers the following mREIT catalysts/factors: 1) projected future MBS price movements; 2) projected future derivative valuations; and 3) projected near-term dividend per share rates. This recommendation also considers the higher probability of one Fed Funds Rate increase by the Federal Open Market Committee ("FOMC") during late 2016/early 2017 (this is a more "hawkish" view when compared to early summer when no rate hikes were projected by most market participants) due to recent macroeconomic trends/events.

Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions. All trades/investments I have performed over the past few years have been disclosed to readers in "real time" (that day at the latest) via the "StockTalks" feature of Seeking Alpha. Through this resource, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered).

Disclosure: I am/we are long AGNC.

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: I currently have no position in ORC or NLY.