ORC - Orchid Island Capital: The Difficulties Are Far From Over

2023-04-19 00:08:06 ET

Summary

• The company decreased its RMBS portfolio in the last quarter which boosted its book value but this was only a temporary solution.
• 2023 is going to be challenging for ORC.
• The main priorities of the management do not include a stable and secure dividend but rather focus on buybacks.

Investment thesis

Orchid Island Capital, Inc. ( ORC ) is the 27 ^th largest mortgage REIT publicly traded company out of 41. Its portfolio is mainly invested in RMBS and longer duration fixed income securities. However, its fourth-quarter results were better than expected the difficulties are not over yet. In the first quarter, the book value per share is likely to decline again, following most of 2022’s trends. The valuation might seem fair but some fundamentals suggest otherwise. Income investors might want to avoid ORC stock as the management’s top priorities are far from a safe and stable dividend.

Earnings Outlook

2022 was a disappointing and difficult year for ORC. The fourth quarter results brought some relief as they outperformed expectations. After a significant book value per share decline, of more than 50% in the first 9 months of 2022 in the last quarter, the company could increase its book value per share by 4.5%. This massive decline was due to the RMBS and asset allocation decisions of the management and party because of the new share issues. From the end of 2021 until the end of 2022, the company’s average shares outstanding grew by a staggering 54%. At the end of 2022, the company's Agency RMBS portfolio had reduced to $3.5 billion. The fourth quarter saw a decline of $3.7 million in interest income compared to previous quarters. In 2022, the company increases the duration of its security holdings and reduced its coupon rate, consequently improving its performance. This has reduced interest income but also resulted in a significant boost to ORC’s book value over the last two months of 2022 and into 2023. I expect this trend to continue in the first and second quarters of 2023, as well with a less positive impact on the company’s NII.

The management is forecasting Q1 GAAP EPS of $0.10, which takes into account approximately $0.33 per share net realized and unrealized gains on RMBS and derivative instruments. This is slightly lower than the previous $0.35 per share EPS estimate. The company also estimates a book value per share of $11.56 as of March 31 which will be a 3% decline Q-o-Q.

External trends affecting mREITs

The high-interest rates, 20-year high mortgage rates, and inverted yield curves had and still have negative effects on mREITs profit margin and net interest income. The increasing rates of interest are usually not favorable for REITs, as they can lead to a decline in the value of the real estate and an increased cost of borrowing money. According to the median forecast of eighteen voting members of the FOMC, there is one expected quarter-point rise in interest rates this year, followed by rate cuts after 2024. Some members have assumed that the Federal Reserve would raise its targeted interest rate to almost 6% in 2023. As per officials' median forecast, the peak fed-funds rate in 2024 is expected to be 4.3% which suggests at least one 25 basis point rate cuts at the end of the year. This will keep mREITs profitability and NII lower for at least the next 2 quarters. In addition, the fear of a potential recession and reluctant lending of banks (which they suggested after their Q1 results) will likely keep treasury yields relatively high. According to a survey made in mid-February of 40 fixed-income strategists, benchmark 10-year Treasury notes are expected to bring an interest rate of 3.71%, 3.66%, and 3.40% over the next three, six, and twelve months respectively. These figures are slightly higher than forecasts published by EconForecasting.

Overall home prices are predicted to lower by 2.3% in 2023. Fannie Mae has forecasted a 1.5% drop in housing prices while Freddie Mac predicted a decrease of 0.2%. This will hurt mortgage originations’ one-to-four-family properties. Since ORC’s large portion of the portfolio consists of RMBS the decline in new mortgage originations will make the management’s position difficult in the short term.

Valuation and Dividend

Looking at the company’s price to book value it is fairly valued, priced a bit under its book value. However, this does not reflect all aspects of the upcoming struggle in the RMBS market and high-interest rates throughout the year.

The mREIT sector has underperformed the S&P 500 index in the last 12 months and, likely, the next 6-8 months will not be different. If investors purely look at the price return of REM and ORC, ORC wins by a slight margin.

On the other hand, income-oriented investors should be cautious with ORC in my opinion. The company lowered its dividend numerous times in the last 10 years and the management is not keen on providing stable and secure dividends. Stock buybacks are more favorable for the management than its dividend.

“We see it (the dividend) as sustainable, and as I mentioned. We were a little short in the fourth quarter, but that's just purely on an income basis. And I also mentioned that the hedges really started to kick in, in the second half of 2022. They really do so this year….and even with these lower coupons, while they do not cover the dividend in and out of themselves, in conjunction with the benefits of the hedge…shortfall in the near-term, which I'm not sure that would be, we still view this as much more desirable.” Robert Cauley - Chairman and CEO

During the fourth quarter, the management conducted a share buyback of approximately 2.5 million shares with a weighted average price of $9.30 per share. If the stock price falls below this amount, according to the management they will consider buying back additional shares. At the same time if the stock price is heading to $12-13 they might issue additional shares. This suggests to me that they are focused on the price return much more than a stable long-term dividend so that is why I would be cautious as an income investor about buying ORC for the long term.

Final thoughts

The company experienced some uptick in the fourth quarter of 2022 but the difficulties are very likely to continue in 2023 as well. The declining book value is likely to continue at least for a couple of quarters despite the longer duration fixed income portfolio and lower share of RMBS in the investment portfolio. Income investors should be very cautious when buying into ORC for dividend income purchases.

For further details see: