Orchid Island Capital's Dividend Projection For March-May 2017

| About: Orchid Island (ORC)

Summary

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 relates 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 March-May 2017 is stated in the “Conclusions Drawn” section of the article.

My buy, sell, or hold recommendation and current price target for ORC is in the Conclusions Drawn section of the article as well.

Author's Note: This article provides a detailed analysis with supporting documentation on the "most probable/suitable" dividend per share rate Orchid Island Capital Inc. (NYSE:ORC) will/should declare for March-May 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 monthly dividend per share rate projection for March-May 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 events and quarterly earnings. 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 14%), many investors have chosen this stock (and other sector peers) for an income-producing equity investment. 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 article 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 March-May 2017. I will also include my BUY, SELL, or HOLD recommendation 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 first-fourth quarters of 2016. All figures within Table 1 are for the "three-months ended" (quarterly) timeframe.

Table 1 - ORC ERTI Analysis (First-Fourth Quarters of 2016)

(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 first-fourth quarters of 2016. All figures within Table 2 have a quarterly timeframe. Table 2 below compares ORC's ERTI to the company's dividend distributions showing the quarterly underpayment (overpayment).

Table 2 - ORC ERTI Versus Distributions Analysis (First-Fourth Quarters of 2016; 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 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 $11.4, $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, 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 (see red reference "J"). This calculates to a quarterly dividend distributions payout ratio of 80%, 100%, and 105%, respectively (see red reference "(I/E)"). 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. Now let us take a look at what occurred during the fourth quarter of 2016.

ORC had ERTI of $10.8 million for the fourth quarter of 2016. In comparison, ORC had dividend distributions of ($12.5) million. When calculated, ORC had an overpayment of ERTI of ($1.8) million (rounded) for the fourth quarter of 2016. This calculates to a quarterly dividend distributions payout ratio of 117%. As such, I believe it can be determined ORC modestly (some could argue materially) overpaid the company's ERTI during the fourth quarter of 2016.

ORC went from having a modest underpayment of ERTI to a modest overpayment of ERTI during 2016. This is due to the fact ORC witnessed a modest increase in repayments/prepayments within the company's 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 addition, ORC witnessed a continued rise in borrowing costs as the year progressed without an offsetting rise in yields.

With that being said, when combining all four quarters together, ORC had an annual dividend distributions payout ratio of 100%. As such, ORC's 2016 net ERTI matched the company's 2016 dividend distributions. In my opinion, considering TEST 1 on a "standalone basis," this evidence helps support ORC's stable dividend during 2016. However, the larger quarterly payout ratios as 2016 progressed should be seen as a cautionary/negative trend.

In addition, 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 - Quarterly 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 net pay rate on ORC's interest rate payer swaps as of 12/31/2016 was 29 basis points ("bps"). ORC's net pay rate actually increased during the fourth quarter of 2016 as management increased the company's net (short) interest rate payer swaps position when interest rates were higher when compared to earlier in the year. In my professional opinion, this is still an attractive net pay rate and is lower than most other mREIT peers who utilize this specific derivative instrument. With that being said, this net pay rate "flows through" the quarterly income statement and currently decreases 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 first-fourth quarters of 2016. Table 3 below compares ORC's 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 ERTI Less Periodic Settlements of Interest and Current Portion of the Deferred Loss on Derivatives Versus Distributions Analysis (First-Fourth Quarters of 2016; 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 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 $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, 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 (see red reference "J"). This calculates to a quarterly dividend distributions payout ratio of 96%, 132%, and 143%, respectively (see red reference "(I/E)"). 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. Now let us take a look at what occurred during the fourth quarter of 2016.

ORC had ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of $7.8 million for the fourth quarter of 2016. In comparison, ORC had dividend distributions of ($12.5) million. When calculated, ORC had an overpayment of ERTI less the company's periodic settlements of interest and current portion of the deferred loss on derivatives of ($4.7) million for the fourth quarter of 2016. This calculates to a quarterly dividend distributions payout ratio of 161%. As such, I believe it can be determined ORC materially overpaid the company's ERTI less its periodic settlements of interest and current portion of the deferred loss on derivatives during the fourth quarter of 2016.

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

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

When compared to ORC, AGNC had a notably lower ERTI per common share figure for the fourth quarter of 2016 (when excluding the company's NDR income). AGNC had quarterly ERTI of $0.15 per common share while distributing three monthly dividends totaling $0.54 per common share. AGNC had a quarterly overpayment of ($130) million. When calculated, AGNC had a quarterly payout ratio of 360%. 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 $0.36 per common share. Still, this was notably below AGNC's three monthly dividends totaling $0.54 per common share for the fourth quarter of 2016. AGNC had a quarterly overpayment of ERTI and NDR income of ($62) million. When calculated, AGNC had a quarterly payout ratio of 152%.

However, it should also be noted AGNC reported quarterly net spread and NDR income (excluding the company's "catch up" premium amortization benefit; a non-IRC metric) of $212 million for the fourth quarter of 2016. When calculated, this was net spread and NDR income of $0.64 per common share. When calculated, this was an underpayment of $32 million.

For the fourth quarter of 2016, NLY reported ERTI, estimated core earnings ("ECE"), and normalized core earnings ("NCE") of $0.44, $0.53, and $0.30 per common share, respectively. As such, NLY's NCE matched the company's dividend distributions of $0.30 per common share for the fourth quarter of 2016. Additional analysis regarding NLY's dividend sustainability will be provided in a future article.

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 first-fourth quarters 2016:

ORC's Q1 2016, Q2 2016, Q3 2016, and Q4 2016 ERTI Dividend Distributions Payout Ratio, Respectively: 80%, 100%, 105%, and 117%

When assessing ORC's near-term dividend sustainability based solely on TEST 1, the company's higher ERTI payout during the second-fourth 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 first-fourth quarters of 2016:

ORC's Q1 2016, Q2 2016, Q3 2016, and Q4 2016 ERTI Less Periodic Settlements of Interest and Current Portion of Deferred Loss on Derivatives Dividend Distributions Payout Ratio, Respectively: 96%, 132%, 143%, and 161%

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 also be seen as a cautionary/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 existing interest rate payer swaps will decrease if the London Interbank Offered Rate ("LIBOR") continues to increase.

Still, similar to the results obtained in TEST 1, TEST 2 provided evidence 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-fourth quarters of 2016. I believe this negative factor puts heightened pressure on ORC to maintain a monthly dividend of $0.14 per share.

If ORC continues to provide shareholders a stable monthly dividend, a growing proportion of these dividends will be classified as a "return of capital" ("ROC") per the IRC.

With that being said, due to the recent notable increase in mortgage interest rates/long-term U.S. Treasury yields during the fourth quarter of 2016, there will be an eventual decrease in conditional prepayment rate ("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 the following probabilities of ORC declaring a stable monthly dividend for the months of March-May 2017:

Probability of a Stable $0.14 Per Share Dividend for March 2017: 50%

Probability of a Stable $0.14 Per Share Dividend for April 2017: 40%

Probability of a Stable $0.14 Per Share Dividend for May 2017: 30%

My BUY, SELL, or HOLD Recommendation:

From the analysis provided above, including additional catalysts/factors not discussed 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 my projected CURRENT BV (BV as of 2/17/2017, a HOLD when trading at or greater than a (5.0%) but less than a (12.5%) discount to my projected CURRENT BV, and a BUY when trading at or greater than a (12.5%) discount to my projected CURRENT BV. These ranges are unchanged when compared to my last ORC article (earlier this week).

Therefore, I currently rate ORC as a SELL since the stock is trading at or less than a (5.0%) discount to my projected CURRENT BV ($10.25 per share). My current price target for ORC is approximately $9.75 per share. This is currently the price where my SELL recommendation would change to a HOLD. This price target is unchanged when compared to my last ORC article. Currently, the price where my recommendation would change to a BUY is approximately $8.95 per share. This price is also unchanged when compared to my last ORC article.

Along with the data presented within this article, these recommendations consider 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 multiple Fed Funds Rate increases by the FOMC during 2017 (this is a more hawkish view when compared to most of last year) 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.

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