Dynex Capital: Growth Investors Can Find It Attractive
Summary
- Dynex Capital is slowly shifting to only agency mortgage-backed securities making the business model more stable and secure.
- With the rise of house prices and the economic recovery, DX had a good 2021 which is likely to continue in 2022.
- DX is a dividend nightmare with numerous cuts and no increases in the previous years.
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Investment thesis
Dynex Capital, Inc. (NYSE:DX) operates in the cyclical REIT business but the cycle is turning in their favor after the pandemic. Housing prices are on the rise and the U.S economy is moderately growing. However, the interest rates are very likely to rise in 2022 tightening DX's profit margin. The stock can be a target for growth investors because it is undervalued but the future growth potential seems limited at the moment. For income-seeking investors, the stock is a big no with 7 dividend cuts in the last 10 years.
Business Model
Dynex Capital is a mortgage REIT (mREIT) and it provides financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments. The vast majority of their income comes from Agency backed assets and only 2% of their investment portfolio is in Non-Agency Commercial Mortgage-Backed Security (CMBS). The company uses leverage to borrow capital to be able to relend it on higher interest.
Financials & Earnings
Q3 results
DX reported good 3rd quarter earnings. Their net income was $0.35 per common share, the EPS outperformed the previous estimate by 10% (EPS actual: $0.54 per share; EPS Previous Estimate: $0.49) Book value per common share was $18.42 in Q3, slightly down compared to Q2 results of $18.75. The company continued growth in equity capital by raising $27.9 million through at-the-market ("ATM") offerings of common stock, bringing year-to-date capital raised to $224.4 million. CEO of Dynex Capital is optimistic about the long term results of the company and the dividend: "We believe the current environment remains favorable for us to generate solid long-term returns. We are pleased to once again have generated returns in excess of our dividend in the quarter," stated Bryon Boston, Chief Executive Officer. I agree with the growth part and the favorable environment, because of the economy reopening, house price rises. However, in terms of the CEO's self-confidence in dividends, I see that from a different perspective. (More on that later in the dividend section.)
The company maintains a flexible portfolio, substantial liquidity, and a significant capacity to increase leverage. The management believes they remain positioned to generate returns that exceed the dividend, which also provides a capital cushion while generating solid long-term returns. DX has been moving from commercial mortgage-backed security and from other riskier assets to safer Agency RMBSs in the last year. As of September 30, 2021, 89% of their capital is allocated to Agency RMBS.
Source: Q3 Earnings Press Release
Valuation
Black Friday and Cyber Monday's market drop made DX's stock a bit more attractive and pushed it to a negative YTD return of -7.5%. That also means the dividend yield skyrocketed to an almost 9.5% yield. DX's forward Non-GAAP P/E ratio seems appealing with 8.43 compared to the sector median of 11.00. But if we take a look around mREITs we can see that DX is fairly valued among them. MFA Financial, Inc. (MFA) mainly operates in the residential mortgage securities sector and has a forward P/E ratio of 7.76. New York Mortgage Trust, Inc. (NYMT) also invests in residential houses, single and multi-family homes and the company has a forward P/E ratio of 8.49.
When evaluating DX stock's intrinsic value, we see an undervalued stock. For the calculations, I used Graham's DCF model. For the last 4 quarters, the official EPS (TTM) was $4.71 but that is a bit unrealistic for future calculations as this high number was mainly because of Q1 2021 exceptionally good results. For the calculations, I used a more realistic EPS number, $2.5. Finviz estimates that in 2022 DX's EPS will be $1.94. To the expected growth rate, I added a moderate 1%. That is because the upcoming growth of mortgages could be offset by the expected interest rate rise in 2022 and 2023. Finviz analysts also calculated a forward 5-year EPS growth which is -3.05% for DX. Put all this data together and we can have an intrinsic value for DX stock between $45-50. If we use Finviz's forward 1-year EPS number, the intrinsic value for DX stock is between $35-37. Only taking into consideration Dynex Capital's P/E ratio, intrinsic value, and recent performance the stock is a buy for both value and growth investors.
Company-specific Risks
The business models of mortgage REITs range from investing only in Agency MBS to investing substantially in non-investment grade MBS and originating and securitizing mortgage loans and investing in mortgage servicing rights. DX mainly invests in agency MBS but there are some internal risks worth looking at.
- A potential interest rate rise will decrease DX's profitably and hurt its profit margin. In a period of rising rates, particularly increases in the targeted U.S. Federal Funds Rate ("Federal Funds Rate"), they may experience a decline in their profitability from borrowing rates increasing faster than interest coupons on DX's investments reset or their investments mature. The company could also experience a decline in profitability from their investments adjusting less frequently or relative to a different index from their borrowings (repurchase agreements are typically based on shorter-term rates). Once the Federal Reserve announces a higher targeted range or if markets anticipate that the Federal Reserve is likely to announce a higher targeted range for the Federal Funds Rate, the company's borrowing costs are likely to immediately increase, thereby negatively impacting their results of operations, financial condition, dividend, and book value per common share. The interest rate rise is likely to happen in 2022 according to the FED.
- DX uses leverage in its daily operations. Leverage increases returns on the company's invested capital if they can earn a greater return on investments than their cost of borrowing but can decrease returns if borrowing costs increase (interest rate rise) and they have not adequately hedged against such an increase. Further, using leverage magnifies the potential losses to shareholders' equity and book value per common share if their investments' fair market value declines, net of associated hedges. Repurchase agreements are typically uncommitted short-term financings with no guaranty of renewal at maturity and changes to terms of such financing may adversely affect DX's profitability and liquidity. Because repurchase agreements are short-term commitments of capital, lenders may respond to adverse market conditions in a manner that makes it more difficult for them to renew or replace on a continuous basis their maturing short-term borrowings and have, and may continue to, impose more onerous conditions at renewal.
My take on DX's dividend
Current dividend
DX is one of the few companies which pay monthly dividends. The current monthly payment is $0.13 per share and the forward dividend yield is an astonishing 9.48%. DX has also been paying a consecutive dividend for 13 years exactly matching the sector median of 13 years. In terms of dividend growth, the management tends to cut the dividend instead of raising it. Since 2013 the management cut the dividend 7 times. That is almost once a year cut, not a dream for an income investor rather a nightmare.
Source: Seeking Alpha Dividend History
Future sustainability
Looking at the payout ratio the dividend coverage seems fine. The future payout ratio will be around 80% which is healthy in the mREIT sector. Although, the payout ratio seems sustainable in the upcoming year the management's dividend policy is not income investor-friendly with regular dividend cuts. The only upside I can see is if someone is exclusively looking for monthly dividend distributions DX could be a fair choice but that investor can also easily find a better monthly dividend payer.
Source: The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.
Summary
Dynex Capital's business model is strengthening with more and more capital directed from Non-Agency Commercial Mortgage-Backed Security (CMBS) to Agency-Backed assets. The company's growth potential is attractive; the only major risk is the rise of the interest rates because it can easily lead to more expensive borrowing for DX. With the currently undervalued stock growth and value investors might find a good place for their money but for income investors there are several red flags not to buy Dynex Capital.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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