Invesco Mortgage: The Right Price

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About: Invesco Mortgage Capital Inc. (IVR)
by: Quad 7 Capital
Summary

The sector has gotten a bit of a jolt from the idea of interest rate cuts.

Dramatic improvement in critical metrics in Q1 were noted and we believe these will stabilize moving forward in 2019, with the worst case scenario being flat interest rates.

One of the few mREITs raising dividend payouts.

A buy in the $15 range as an attractive discount would be had.

We believe Invesco Mortgage Capital (NYSE:IVR) is improving. Although the pressure on the sector has been strong over the last five years with rates rising, the sector has gotten a bit of a jolt from the idea of interest rate cuts. While that remains to be seen, we will say that fears over rising interest rates are for good reason, but given the climate, we think the worse case right now is rates hold firm for the next 6 to 12 months. That bodes fairly well for mREITs, and while we traded this name earlier in the year, we now believe the income should be stable. Invesco Mortgage has become a strong pick in the sector for a steady stream of income that is currently safe from a dividend cut. Invesco has a diversified investment strategy that we like. The key metrics we utilize to analyze mREITs suggest the stock is fairly valued, while the dividend having recently been raised will be maintained. Thus, we believe at present the stock is a hold, but in the $15 range is a buy. Let us discuss.

Summary of performance in Q1

In this column, we will look into the critical metrics which are summarized below for Invesco Mortgage Capital as of Q1 2019:

Key Metrics of Interest

Invesco's Performance

Q1 2019 Book value and % change from Q4 2018

$16.29 (+6.7%)

Net interest rate spread in Q1

1.11%

Dividend (yield)*

$0.45 (11.1%)

Q1 Core Income

$0.47

Dividend covered?**

Yes

52-week share price range

$13.67-$16.66

*Based on current share price and forward annualized yield

**Determination based on estimate of core earnings covering dividend paid; however caution should be exercised in interpreting the core earnings measure across companies in the sector. It is also not a measure that should be a complete substitute for net income

Data table source: Invesco's Q1 earnings, graphics by BAD BEAT Investing

Let's talk about net income and core earnings

As interest rates rose we saw a simultaneous flattening of the yield curve over the last five years. Recently however, things have improved, but no company was immune to the impact in the sector. Companies that were more diversified seemed to hold up better. Of course IVR stock itself has rallied hard from the lows to start the year, and we think that this rally was justified when we look at the fiscal performance of the company. With the investment climate for the sector, Invesco’s portfolio mix, and competent management, the major critical metrics we follow for mREITs saw significant improvement. Naturally, Invesco wasn't alone, as a few other powerhouse names in the sector have fared better of late. That said, we continue to believe that Invesco perform well in 2019, more so if the rate environment improves, but the name will be fine even if they hold steady.

Turning to the actual data, performance, Invesco's results reflected the impact of ongoing portfolio repositioning, lower effective costs of funds, and using stock sale proceeds to park money into accretive investments. This worked very well for the company and we applaud management. We were pleased with net income as a whole as it turned from a large loss in Q4 2018, to a positive return here in Q1. Our expectations were for a positive return which predicated on the company seeing improvement in its critical metrics relative to Q4, while factoring in the performance of competitors and the impact of rates during the quarter. Net income came in at $127 million of $1.05 per share. The net interest income figure is perhaps more relevant. This figure was about flat from Q4 2018 at $74.1 million as total interest expenses rose. We had assumed net income would come in between $72-$75 million, away up from last year and around the same as Q4 2018. This is a similar pattern to what we noted in competing mREITs. The improvement in core earnings over the last year is clear:

Source: SEC filings, graphics by BAD BEAT Investing

Now, net interest income is important, but we really care about core earnings, which are a strong proxy for dividend coverage. Here in Q1, core income was $56.9 million, an increase of $6.1 million or 12% from the sequential quarter. Core earnings improved thanks to big returns on investments, net interest income, though it was tempered somewhat by losses on derivatives. That said, we believe that this strength will continue in 2019. Considering our net interest income expectation, we were looking for around $0.45 to $0.46 in core earnings. We were impressed by the core income result, but not necessarily surprised. That said, this core income in addition to recent spillback coverage allowed the company to raise its dividend from $0.42 to $0.45 in the quarter. Other mREITs have cut dividends in recent years. Invesco has now raised it again, and brings the dividend back to 2015 levels. With such strong core income, this dividend hike is solid. We believe it is very bullish, and is in part why the stock rallied so much this year. While the current payout is still way below the payout level several years ago of $0.55. However, we see the dividend as secure and likely to grow should conditions remain favorable.

Net interest rate spread

Many mREITs in Q1 saw spreads narrow slightly and Invesco was no exception. The net interest rate spread, which is a main biggest driver of net interest income, narrowed slightly from Q4, which explains in part the narrowing (nearly flat) to the total net interest income in the quarter. Obviously if we compare the present quarter's numbers to that of a few years ago, there is a stark contrast. These companies are operating in a much more challenging climate now, despite some of the relief in rate movements. Still, if you are invested here, you need to be watching this critical indicator for the earnings potential of an mREIT. Invesco saw a spread of 1.26% in the quarter narrowed 5 basis points from 1.31% last quarter.

That said, we should really examine the adjusted form of this measure, the "effective annualized" figures, which, in contrast to the unadjusted figures, suggested a slight improvement. Based on these measures, the yields were stronger while cost of funds were lower than Q4 2018. That is a winning combo. The effective annualized yield on its portfolio was 4.00%, rising 2 basis points quarter-over-quarter, and the effective annualized cost of funds was 2.68%, falling 6 basis point from 2.74% last quarter. Taking the difference, we see that the effective net interest spread actually widened 8 basis points to 1.34% from 1.26%. We like what we see here, and it helped boost book value

Book value suggests we are at fair value

We also want to touch on the book value of the company. You see, along with the dividends being paid, book value drives the share price of mREITs. The book value can help inform us if an mREIT stock is trading at a discount, at a premium, or is about fairly valued. While some of this depends on momentum in the sector and/or expectations for the future, when deciding on a possible purchase of common shares of an mREIT, examining this metric is critical.

Generally speaking we like to buy when there is a large discount-to-book. The larger the discount an mREIT is offering, the larger the margin of safety will be if you make a purchase. We watched book value fall for years. This quarter, book value rebounded, as did the stock. We no longer have a discount, and we do not believe big gains in book value are likely to continue (though we do suspect it to stabilize). At the current share price of $16.25, we are trading essentially at book value, which rose 6.7% in the quarter to $16.29. With this stock, we believe you need to time it so that you are getting a bargain. Right now, its fair value. It is paying a fantastic dividend yield. We think new money should wait. Those in the stock should hold and enjoy the current climate of strength

Final thoughts

All things considered, we would be holding the stock until the discount-to-book returns, preferably with a 10% or more discount versus book value. The only exception to this would be if we anticipated book value to continue to show significant appreciation. The present jump reflected tighter interest rate spreads across credit assets and gains in the company's Agency CMBS and specified pool Agency RMBS. While we think assets can see more gains, we do not anticipate a significant rise in book value in Q2. In fact, given the climate over the last few months it is likely that the majority of residential mortgage REITs will see a loss in book value per share. We're also watching to see if the Federal Reserve cuts rates, which could lead to financing asset purchases at lower rates, so that is something to keep in mind as well. For now, we like the common stock here as a source of income for existing shareholders.

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.