Western Asset Mortgage: Why Another mREIT Dividend Cut Is Not All Bad News
Jun 30 2013, 06:19 | about: WMC
Lately, investors have lost serious capital in mortgage real estate investment trusts (mREITs). This article is being written in specific response to reader demand for follow-up coverage on Western Asset Mortgage (WMC) which, like its peers, has also seen a large selloff in the last two months and has responded with reduced dividend payments.
Yield Is Sky High
This big draw to WMC is that it currently offers an incredible 20.4% dividend yield on its quarterly dividend of $0.90 per share at the current share price of $17.65. The company has a diverse asset mix consisting of residential mortgage backed securities, asset backed securities and commercial mortgage backed securities. Additionally, since the company is moving in the direction of being a hybrid mortgage REIT, it also invests in non-agency RMBS. Further, it will likely be moving into the commercial mortgage business, a trend which many of the residential REITs have been following. Therefore, WMC offers (or will soon offer) potentially complete diversification within the mREIT sector. However we must look at how business went in the first quarter to understand what to look for in coming quarters.
Key Items In The Q2 Report I Will Be Looking For
The most recent WMC earnings report followed the trend of disappointing results in the mREIT space. The current quarter is likely to be painful as well, as evidenced by the selloff in the stock price and the slight dividend cut. I have high hopes for WMC going forward given its slightly different business model. I will be looking for the change in the following Q1 metrics during the Q2 report: First off, WMC reported a Q1 net loss of $28.5 million, or $1.18 per share. The company cannot afford to report many more consecutive losing quarters, and despite any hedges that were in place in Q2, it will likely be a bad quarter. I think this is baked into the stock price. In this Q1, loss was $54.8 million of net unrealized loss on RMBS and other securities, $13.9 million of net realized loss on RMBS and other securities (including other loss on residential mortgage-backed securities of $2.3 million), and $15.4 million of net gain on derivative instruments and linked transactions. These unrealized losses were high, similar to competitors' reports. In Q1 WMC generated core earnings of $22.6 million, or $0.93 per basic and diluted share. Net interest income for the period was $28.6 million. WMC's weighted average yield on its portfolio was 3.04%. I will be looking at the performance of each of these metrics, but it is important to be aware that Q1, and most certainly this Q2, have been anomalies. The key going forward is how will the company reposition itself during this turbulent time?
How WMC Can Prosper in a Rising Interest Rate Environment
I recently opined that WMC could raise its dividend down the road. I still believe this to be true. Despite evidence to the contrary (this quarter has been an atrocious environment for mREITs), I thought the WMC dividend was going to be maintained. I was incorrect, as it was cut slightly to $0.90. Still, the WMC yield is currently over 20% assuming continued quarterly dividends of $0.90 per share. WMC had finances to cover the dividend, but likely chose to cut in order to reposition some of the portfolio and to prepare for a few more turbulent months. In Q1 WMC generated over $52 million in cash from its operations while it paid $27 million in dividends. This leaves cash flow available to invest in the recent sale we are seeing in the MBS, which I think it may be taking advantage of by levering up. WMC is required to pay 90% of REIT taxable income but this does not necessarily have to be the case quarter to quarter. It has flexibility, provided it meets the 90% threshold annually. What we need to be concerned with is that WMC's taxable income is tied to the change in the interest rates. In the prior article I cited WMC's sensitivity analysis showing that if rates go up 50 basis points, WMC would expect to report a 13.9% increase in the coming quarter's net interest income. If rates go up 100 basis points, then WMC estimates an increase in net interest income of 19.0%. Rates are already on the rise and this rise is expected to continue. The only concern would be if short-term interest rates rise too sharply, which WMC notes could reduce income. All things considered, WMC has designed its investment strategy to take advantage of a rising interest rate environment.
Book Value Held Up Well In May
When WMC recently announced its amended dividend of $0.90, it also gave an updated book value. At the end of Q1, book value was at $19.42, having dropped about 10% from its fourth quarter. Since May was a terrible month for the mREITs, it was widely expected that book value for these companies probably came down by another 10% or more that month. To my pleasant surprise, book value was reported as of May 31, 2013 to be $19.25. This is less than a 1% decline in a month where MBS values plummeted. While it is good news, the month of June has been less than stellar to say the least, so book value may come down even further. Despite this fact, I doubt that WMC's book value will drop significantly in June given the negligible decline in May. At its current price of $17.35, if book value drops another 9%, WMC will still be trading at a discount to book value. Thus, I think there is some value here, especially with its resilient positioning and high yield.
Conclusion
The pain has continued in the mREIT sector. We are looking for interest rates to settle down. WMC has taken necessary steps to thrive in a rising interest rate environment. What is critical to the stock going forward is exactly dependent on what management does to reposition during this changing market. If the correct decisions are made and the sensitivity analyses are accurate (and statistically precise), I could see the dividend easily being maintained if not raised again down the road. While 2013 has indeed been an awful year for this young company, it seems to be positioning well for the future. I am long the stock, most recently adding to my holdings at $17.50 a share. I will look to add further should the stock fall to $16.70. Finally, I will be watching interest rates, MBS values and awaiting the company's report next month.
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