PMT - Dynex Capital: Reexamining That Dividend Cut Call

2023-11-01 16:19:54 ET

Summary

• Dynex Capital, Inc.'s predicted dividend cut did not happen.
• We analyze what went wrong and why avoiding the stock still worked out for those that bought our thesis.
• We examine where this goes from here and weigh in on the preferred shares as well.

Not every thesis pans out exactly as an investor evaluates it. Taking a look back, though, is an essential learning experience. What worked, what did not, and most importantly, the "why," are key to improving your performance. Let's look at Dynex Capital, Inc. ( DX ) and our call for the dividend to be cut, through that lens.

What Was Predicted

So here is the cut prediction. Clear as day.

Our forecast is for another reduction to the dividend and we are likely looking at about 10 cents on a monthly basis or $1.20 annually. This would be on the low side, if we see the historical correlation between book values and dividends paid for the trailing 12 months.

But one that we think is highly likely in the rough environment ahead. We rate the shares a "hold" and think the preferred shares are relatively a better here.

Source: Dividend Likely To Be Cut To 10 Cents A Month .

What Actually Happened & Why

Dynex has obviously still not cut the dividend and the 13 cents a month number continues . But our forecast was made on the fact that actual owner's earnings will be really poor for Dynex. That forecast turned out to be about as accurate as it gets. Tangible book value per share has dropped by $2.58 per share since that article was released.

This is almost double the dividend paid over this timeframe, of $1.30. This numerical ratio also holds true for the total returns over this timeframe. If you avoided the stock, you are likely ecstatic.

It is clear that based on changes in book value, that the dividend was not earned. So what made the payout continue? Well the third quarter transcript (as well as earlier quarters) points to this.

In the third quarter, Dynex had net hedge gains of $217 million and have unamortized net hedge gains of $830 million at quarter end. These hedge gains help to offset increase in financing costs. As of now, we're projecting the fourth quarter to have hedge gains of $24 million, or $0.41 per share. The total amount of gain to amortize and to REIT taxable income can go up or down, depending on the hedge position and movement in rates in the future. Dynex ended the third quarter with an unrealized gain on its hedges.

Source: Q3 2023 Conference Call Transcript .

So, there you have it. Hedge gains. We see yield-chasing investors point to these as if they actually solve their problems. Unfortunately they do not. Hedge gains are marked to market on every 10-Q. So when Dynex "crystallizes" these, that just means they are flowing out of the balance sheet into the income statement. So, the tangible book value that represents these gains is lost in the quarter. Sure, on the income statement side, you see the offset. But our point is that at any given time, the hedge gains are already reflected in the tangible book value. Dynex made no real money over the last 12 months. That is why after dividends and crystallization of those gains, the tangible book value fell.

What's Next

If you need solace that there are still "hedge gains" to save your dividend, you have it.

In the third quarter, Dynex had net hedge gains of $217 million and have unamortized net hedge gains of $830 million at quarter end.

Source: Q3-2023 Conference Call Transcript.

Of course, that $830 million is included in the tangible book value. In fact, that $830 million is even larger than the market cap.

So, you can have a lot more quarters where Dynex talks about this hedge gain being used to pay you dividends. But the core business looks in trouble. Interest income has lagged interest expense in each of the last 3 quarters.

This is problematic of all mortgage REITs, or mREITs, and some have done better and others have done worse than Dynex. It is a tough climate, and Dynex's book value is likely lower today than where it stood at the end of Q3 2023.

Bose George

Hey, everyone. Good morning. Actually, first I wanted to ask that you guys noted book OAS is at 14 basis points -- 15 basis points this quarter. Can you just give us an update on what that means for book value?

Smriti Popenoe

Yes. Hi, Bose. The number I quoted was actually as of a couple of days ago. So the number since quarter end is closer to 25 OAS on our portfolio. And the book value has been volatile somewhere between 10.50 and 11.50 as of last week per share, so that's where it's been ranging.

Source: Q3-2023 Conference Call Transcript.

Dynex Capital, Inc. stock remains risky at this stage, despite the big drops that we have seen. When you run leverage at 7X and 8X tangible book value, then tail risks get quite high. These have been made worse with the rapid tightening and unloading of mortgage-backed securities by the Federal Reserve. Over the last decade, Dynex's total return has been weak, thanks to massive book value erosion.

For those just happy to collect the dividend, always keep in mind that dividends and stock price, both follow tangible book value.

At present, we rate Dynex and in this sector at "hold." Trading from the long side seems tempting whenever the stock trades under tangible book value. But long-term erosion of book value makes this a poor exercise. A stock can be "undervalued" at $14 when tangible book value is at $16, and next quarter the drop of book value to $13 can make it the same stock "overvalued."

Dynex Capital, Inc. 6.9% SER C PFD ( DX.PR.C )

DX.PC offers a fixed 6.9% yield on par currently, and that works to a stripped yield of 7.90%. This is an extremely low yield in the mortgage REIT space today. The appeal, though, comes from the floating nature in two years. DX.PR.C floats on April 15, 2025 (unless called) at a LIBOR plus 5.461%. That is a huge spread to the extinct LIBOR. The likely SOFR spread would be even higher. The biggest appeal, though, is the relative buffer of the common equity. We look at this as a total equity (market cap used a rough proxy) to preferred equity.

Compare that to any other mortgage REIT. Dynex's ratio is one of the best. PennyMac Mortgage Investment Trust ( PMT ) is shown below as one example.

So, Dynex Capital, Inc. preferred shares have some relative appeal for those that believe that the "higher for longer" environment is here. We are aiming for more fixed rate securities here and also want less balance sheet volatility. Hence, this is a pass for us.

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