Western Asset Mortgage Capital: Recent Dividend Cut And Declining Book Value

Summary

• The management had no choice but to cut the dividend in March by 33% which translates to a forward dividend yield of 10.88%.
• The management has been restructuring WMC’s investment portfolio to residential real estate assets and exiting commercial ones.
• The stock is fairly valued with declining book value per share and negative economic return in 2021.

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Investment thesis

Western Asset Mortgage Capital Corporation (NYSE:WMC) had a rough 2021 and 2022 seems dreadfully similar. The management has started to restructure the company's investment portfolio in the fourth quarter to exit from shareholder value destroyer assets in the commercial loan space and instead focus on residential real estate assets. They also had to cut the dividend by 33% due to the losses in 2021. I am neutral on WMC because I see the chance that after the portfolio transition the company might return to profitability and management will be able to slowly grow the book value. There is only one downside: this is a bit far from now due to the likelihood portfolio restructuring will finish at the end of 2022.

Business Model

WMC is a micro-cap mortgage real estate investment trust. It is the 40th in terms of market cap among the 41 publicly traded U.S. mREITs. The company had its IPO in May 2012 and it has a total price return of -92.04% up to now. The IPO price was $18.47 and now it trades at approximately $1.5 per share. The largest drop was due to the COVID-19 crisis. There was no liquidity in the MBS markets, which drove margin calls and book value declines across the sector and WMC was heavily hurt by these market conditions. The credit-sensitive part of their portfolio crashed along with the book value and its share price. WMC became a much smaller mREIT than before the pandemic. The price went down from $10-11 per share to a shocking $2-2.5 per share right after the COVID-19 crash in March 2020. The company mainly invests in Securitized Commercial Loans and Residential Whole Loans. These 2 asset types are responsible for 88% of their current portfolio. Most of the company's residential whole-loans are in the Western region (74.6%) while 81.2% of their commercial loans are concentrated in the Northeast region.

Fourth Quarter 2021 Presentation

Financials & Earnings

Q4 and full-year results

In December 2021, management made it clear that they want to do a major portfolio shift to residential real estate-related investments. In the fourth quarter, we could have already seen this change because looking at only the fourth quarter, 53.6% of the investment were residential whole loans, and another 10.4% were Agency and Non-Agency RMBS. The management expects that this portfolio transition will require at least 12 months. At the same time the company sells its commercial real estate portfolio assets, they sold $27.5 million of non-Agency CMBS, and also the management exited from a hotel and the company will receive approximately $6.7 million from that sale.

The CMBS market crashed in just a few weeks in 2020 due to the pandemic. "New issuance within CMBS fell by 45 percent - conduit down 37 percent, SASB down 48 percent, and CRE-CLO down 56 percent - due to lower loan volumes from issuers as pandemic uncertainty persisted - Guggenheim." Because of this, the management had to suspend the dividends to preserve some liquidity. I would not blame the management for having a commercial loan portfolio, a lot of other mREITs had the same however, WMC's net interest rate spread was shrinking in the long term since 2016. I believe this was one of the main reasons why the portfolio crashed so badly and the management had no liquidity. Over the years this below the industry average net interest rate spread caused the liquidity crisis alongside the pandemic. Now, the management tries to refinance the operations as fast as possible with longer-term fixed-rate loans to benefit from the rise in interest rates. This is why they completed the securitization of residential whole loan assets at a weighted average interest rate of 3.1%. In my opinion, if the management succeeds in restructuring residential real estate assets it could stabilize WMC's place among the mREITs due to the residential real estate market expectations in the upcoming years. Both the total home sales and the home prices are expected to grow in 2022 and 2023. According to expectations, the housing inventory will remain low (this is possible due to the extreme increase in basic material and labor costs) while the demand is likely to remain high, especially in the Sunbelt region.

WMC had a rough fourth quarter and a difficult 2021 and I do not expect that 2022 will be much better. The NII plummeted by 46.8% in Q4 compared to the previous quarter and by 56.8% on a year-on-year basis. The company reported a negative $0.11 per share revenue and a negative $0.21 EPS. The economic return on book value was also disastrous, a -5.5% in the fourth quarter and the full-year return was -18.1%. I believe this trend is likely to continue in 2022 due to the portfolio restructuring and the more hawkish Fed policy.

Valuation

In my opinion, the current stock price reflects the transition of the portfolio and the company is fairly valued. The price to book ratio fell from 0.7x at the beginning of 2022 to 0.45x by the end of April while the YTD price return is -33.78%. The stock has been traded at an average P/E ratio of around 8x pre-pandemic but in 2022 the P/E ratio fell to 7.2x and by 2021 it fell further to 6.55x. However, this does not suggest that the company is undervalued. At the moment I see no chance that the company will be able to return to pre-pandemic book value and its pre-pandemic net interest income levels. After the portfolio restructure there might be a chance that the book value per share will start to rise but that is at least 9-12 months from now.

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Company-specific Risks

The largest risk factor I see is portfolio restructuring. We can already see that several assets will be sold at a loss and the residential assets might not deliver the expected return. This is why the stock has been under pressure for the last 8-9 months. In addition, if the transition will not succeed the management will have to cut the dividend again which will not ease the pressure on the company. We saw an inversion in the yield curve at the end of March. It is especially bad news for WMC because when short-term interest rates exceed longer-term interest rates the company's borrowing costs could exceed its interest income. Both long and short-term interest rate rises are unfavorable for the company at the moment. When short-term interest rates start to increase it will increase the amount of interest owed on the repurchase agreements and the financing cost will rise for WMC. The management currently tries to solve this issue with the securitization of residential whole loans. When the long-term interest rates increase significantly (and now as analysts expect the Fed to raise interest rates 6 times in 2022) the market value of WMC's investments will decline, and the duration and a weighted average life of the investments will increase.

My take on WMC's dividend

Do not be fooled by the 14.97% ttm dividend yield because the management cut the dividend recently by 33%. WMC paid $0.06 per share but the management had no choice but to cut the dividend in March 2022 to $0.04 per share. This means the company has a 10.88% forward dividend yield. With this cut, the dividend seems sustainable in the short term but due to the company's portfolio restructure I cannot predict safely a long-term payout ratio trend. It highly depends on how many assets will be sold at a loss, how the interest rates will rise in the second half of 2022 and how the short- and long-term interest rates will behave toward each other. What I see at the moment is that the recent 33% dividend cut was enough to make the dividend sustainable for 2022.

The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.

WMC could hardly be a primary choice for investors. At the moment I see many risks associated with the portfolio restructure, but there is a chance the company could finish the transition with minimal losses, and then the new mainly residential asset portfolio will perform well in the rising interest rate environment. The management is also keen on lowering their financing costs to protect WMC from rising interest rates. However, I believe there are several other mREITs with similar dividend yields that are a much safer choice for income-seeking investors. If you are looking for a stable residential mREIT you might want to take a look at MFA Financial (MFA) with a diversified residential portfolio or PennyMac Mortgage Investment Trust (PMT) with a 12%+ dividend yield.

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.