This mREIT Is Back From The Brink

Summary

• After being bearish on the name for two years we got behind IVR in late fall 2017.
• We believe the company's portfolio mix is well suited for handling volatile interest rates and the critical metrics support this notion.
• The dividend is once again on the rise, but the valuation of the name is peculiar.

We believe Invesco Mortgage (NYSE:NYSE:IVR) is improving. After being bearish, we changed our tune when shares hit $16.86 a share last fall. While the mREIT sector has seen pressure thanks to fears over rising interest rates, we continue to believe that Invesco Mortgage has become a strong pick in the sector for a steady stream of income that is currently safe from a dividend cut. We believe this because the key metrics we utilize to analyze mREITs suggest the stock is a bargain at current levels relative to book value, while the dividend is being comfortably covered. Let us discuss.

In this column, we will look into the critical metrics that you need to be aware of when deciding whether to invest in an mREIT. The critical metrics which you should examine for all mREITs are summarized below for Invesco Mortgage as of Q4 2017:

Critical metrics of interest	Invesco's performance
Q4 2017 Book value and % change from Q3 2017	$18.35 (+0.1%)
Net interest rate spread in Q4	1.83%
Dividend (yield)*	$0.42 (10.6%)
Q4 core income per share	$0.47
Dividend covered?**	Yes
52-week share price range	$14.72-$18.86

Click to enlarge

*Based on current share price and forward annualized yield

**Determination based on estimate of core earnings covering dividend paid

Data table source: Invesco's Q4 earnings

Q4 net income and core earnings

We know interest rates are on the rise, and investors are concerned. We have seen pain from a number of other mREITs in the sector, but Invesco’s portfolio mix, and structure, is well prepared for this environment. Additionally, the credit profile of its investment portfolio continues to strengthen because of further improvement in residential and commercial mortgage fundamentals. While Invesco may not be entirely immune to rapidly rising rates, we think that Invesco will continue to perform well based on its portfolio mix, management team, and trajectory in performance to date.

As for performance, Invesco had a much-improved quarter compared to Q3 (which was very strong in its own right). First, we want to point out that the company surpassed our expectations on the top line significantly. We were looking for net interest income of $86 million (flat from Q3), while the company reported $93 million. Our expectation was predicated on the company performing similarly on its critical metrics relative to Q3, while factoring in the performance of competitors and the impact of rates in Q4. However, performance was better than expected. This net interest income figure of $93 million was up 16% from last year’s $82.9 million, and up 8% from last quarter’s $86 million.

Why does this matter? It shows a turnaround is underway, and the trajectory is improving, despite the volatility noted in rates in the quarter. Core income has consistently improved since Q4 2016:

Source: SEC filings, chart made by author in Excel

Here in Q4, core income registered at $52.5 million, or $0.47. Considering our net interest income expectation, we were looking for $0.44 to $0.45 in core earnings. We were blown away by the $0.47 measure, which easily covered the dividend of $0.42.

While income has improved and the dividend is once again starting to be raised, our enthusiasm is tempered by the reality that the payout is still way below that payout several years ago of $0.55. With these results, have the key metrics improved?

Let’s talk spread

Compared to a few years ago the key metrics are comparatively weak, but are improving. We are impressed that the portfolio is delivering like this. So, let’s talk about the biggest driver of net interest income – the net interest rate spread.

The net interest rate spread is a critical indicator for the earnings potential of an mREIT. Invesco saw a slight increase here as the spread of 1.83% in the quarter widened 4 basis points from 1.79% last quarter.

That said, we should also examine the adjusted form of this measure, the "effective annualized" figures. The effective annualized yield on its portfolio was 3.46%, rising 10 basis points quarter-over-quarter, and the effective annualized cost of funds was 2.09%, rising just 3 basis point from 2.06% last quarter. Doing the simple math, we see that the effective net interest spread widened to 1.37% from 1.30%.

We believe this stability in the spread is a strength as it leads to more predictable income, so this result, and the recent trajectory in this metric, is a positive.

Valuation: The bigger the discount the better the margin of safety

Book value drives the share price of mREITs in conjunction with the dividends being paid. The book value indicates if an mREIT is at a discount, at a premium, or fairly valued. While some of this depends on momentum in the sector and/or expectations for the future, when deciding if to make a purchase of common shares of an mREIT, you need to look at this metric.

In general, provided the trajectory in critical metrics are not glaringly negative, the bigger the discount-to-book an mREIT is offering, the larger the margin of safety will be if you make a purchase. Considering we have seen a number of positive pieces of data, we are further encouraged that Invesco reported a quarter-ending book value of $18.35, rising a penny from the $18.34 to start the quarter. This is also up 5% from the $17.48 we began 2017 with. This rise in book value is pretty significant from our viewpoint, however the stock is still on sale here.

While this stock has been trading at a discount for some time we believe the discount is now very attractive. The key metrics have stabilized/are improving now. While the steep discount-to-book assigned was implying the discount was there because the Street saw this name declining in performance, there remains a sizable discount and performance has remained strong. Sure, rates will be on the rise in 2018, but the company is positioning accordingly, and we believe fears are overblown, especially since the Fed has telegraphed the increases.

At the current share price of $15.80, the discount has widened when we factor in the recent decline in shares and the rise in book value. The stock now trades at a $2.55, or a 13.9%, discount. That is a sizable discount. While this is not as a deep of a bargain as when the stock traded at a 37% discount-to-book, keep in mind that the fundamentals have improved in the name.

Our take

There is no denying that the data has improved. We are very pleased with the key metrics and the fact that the dividend is rising.

Although there are fears of the impact of rising rates, and this has caused REITs in general to trade lower, we feel this discount is inappropriate given how other competitors, which are struggling to cover their dividends relatively speaking, are trading at book or at a small discount-to-book, even after recent selloffs in the sector.

This was a phenomenal quarter, and well above our expectations. It is also the 4^th strong quarter in a row, despite volatility in rates. While the company already cut the dividend payout a few times before, the small hike in the payout as well as the stabilization in book value is a sign of strength. We think the name is a buy for income.

Analyst’s 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.

Comments

[mikefconnell]

Olympic skaters can do triple flips, etc...this ice is too thin for my preferences

[mjtroll1]

regarding this statement

I was interested in this company but... Has a negative PEG ratio over on the Fidelity website stock screener. Looks like it has a lot of Debt.

not applicable to MREIT'S as they pay out 90% of their earnings and by definition use leverage as basis of business model

[mikefconnell]

I was interested in this company but... Has a negative PEG ratio over on the Fidelity website stock screener. Looks like it has a lot of Debt.

[mjtroll1]

good article..the ivr/rem pair has seen ivr be a multiyear outperformer.. below are z scores based on horizon (- cheap)

1yr -2
3yr 0
5yr +.5

so while cheap on 1yr horizon its fair to rich on longer time frames the rem/jnk has seem to have bottomed after underperforming for several months ..comments welcome