ORC - Orchid Island Capital: Another Heavy Leverage High Yield REIT

2024-01-10 20:44:14 ET

Summary

• Orchid Island Capital is a high-yield mortgage REIT that leverages mortgage-backed securities to offer attractive dividends.
• The company faces risks from high interest rates and prepayment of mortgage-backed securities.
• Despite challenges, Orchid Island has maintained a strong payout and is poised for a rebound with a sub-1 price/book value and a yield of 16.6%.

High yield REITs are one of my favorite things. It wasn’t so long ago I was singing the praises of ARMOUR Residential , for both its double-digit yield and its management of high leverage. Today I’m going to be again looking at a similar mortgage REIT , Orchid Island Capital (ORC), which is all of those things and then some.

Orchid Island again trades in mortgage-backed securities, called MBS, and leverages them with both repurchase agreements and derivatives to try to manage things in times of trouble, which Orchid Island makes clear is chiefly about interest rates.

By the Numbers

(source: Most recent 10-Q)

Orchid Island offers three times the cash on hand as they have shares outstanding, and the price/book looks very attractive at under 1. The debt/equity, at 9.6, shows a considerable amount of leverage taken, which is how they offer such high dividends.

How high? They are less than in the past but still competitive if one remembers the 1 for 5 reverse split which came in August 2022 . Taking that into account, the current dividend is in line that which was paid in 2018.

Paying 12¢ a month in dividends, we come up with $1.44 annually. At the current price, we get a yield of 16.6%, a very nearly unparalleled return. Not bad for a company which has been in such a bad environment the last couple of years.

The Risks

And when we start looking at the biggest risks faced by Orchid Island, the company is very forward with the potential problem of high interest rates, which have absolutely been killing them in recent years. They even offered a handy list of estimates of what the different rates would mean.

(source 10-K)

We’ve seen how a high interest rate can absolutely harm this company and its value, but the alternative is that a low interest rate can be very good for the company. So we know what to root for.

The nice thing is, in an election year there is every likelihood officials will drop the interest rates to try to goose the economy. If it does happen, Orchid Island would rise. Another analyst recently said they expect the interest rates to start to ease and REITs to benefit. Orchid Island clearly agrees.

Another potential issue identified by the company are prepayment of the mortgage-backed securities held, and how difficult it might be to replace such securities with those of similar yields.

A Strong Payout

Again, it looks like the dividends paid in a calendar year absolutely cratered in 2022 and 2023. But again, we need to remember the reverse split happened then, and of course they couldn’t maintain the payouts during such a dreadful environment. It happened to the best of REITs, and it happened to Orchid Island as well.

The nice thing is, again, a $1.44 payout in FY2024, which is what we’re looking at barring a big recovery from interest rate cuts, is still a 16.6% yield, which is still a lot of money for potential new investors.

As with some other mortgage REITs, Orchid Island notes REIT requirements are to distribute 90% of REIT profits, and they make a habit of and intention to distribute 100% to the unitholders.

Free Cash Flow

(10-K and 10-Q from the SEC)

In the difficult 2021-2022 market, we saw a net portfolio loss higher than normal, and driving a diluted EPS deep into negative territory. At the same time, the mortgage-backed securities are capable of really generating a lot of cash.

(10-K and 10-Q from the SEC)

Net cash from operations is strong, as it should be, but in the 2021-2022 market, we saw net cash from investment and financing were absolutely terrible. This is a function of the company trying to hedge against the higher interest rates and protect what they have. It was a necessary evil, and even in the first nine months of 2023, the financing was able to keep things from being too dire.

If the market for REITs even goes back to 2020 levels, we can expect positivity in cash flow going forward, and likely a price/book that is even more value investor-minded than what we already have.

Conclusion

With a sub-1 price/book value and a yield of 16.6%, it’s no surprise I would be bullish on Orchid Island. The company has weathered the storm in recent years, and is absolutely poised for a rebound.

More than even most bullish REIT SEC filings, Orchid Island makes clear they understand not just the business, but also how the interest rate impacted them during the bad old days. That they were able to come out of that period with the same high leverage is really commendable, as the temptation must’ve been to unravel the business and try to piece it back together with newer, higher rates.

It is lucky they didn’t try that route, as the prepayment problem got worse with adjustable rate mortgages in the higher rate environment. Fixed rates were no doubt harder to come by with the rates so high, but surely the prepayment problem would hold true for them too, or at least set the stage for a mass of refinancing.

Given the uncertainty of when and where we get the lower interest rates, investors should keep in mind this needs to be bought with a long-term window. If we can collect 16.6% while we wait for the better environment, there are worse fates, and ultimately, there is a high return that is just begging to happen.

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