STWD - Starwood Property: Weak Financial Results Vs. High Dividend Yield

2023-05-17 07:31:54 ET

Summary

• Starwood Property’s financial results in 1Q 2023 were weaker than in 1Q 2022 and 4Q 2022.
• The effect of hiked interest rates on STWD’s interest expenses is stronger than their effect on the company’s interest income.
• STWD’s foreign currency gain in 2Q 2023 may decrease further.
• Thus, Starwood Property’s distributable earnings may decrease to below $0.48 per share in 2Q 2023.
• STWD stock is a hold.

Starwood Property Trust ( STWD ) stock price decreased by about 20% in the past three months as the company reported not strong first-quarter financial results. In the past year, STWD’s financial results were negatively affected by high inflation rates, high interest rates, and global economic headwinds. Despite decreeing net income and distributable earnings, the company managed to pay a dividend of $0.48 per share, flat YoY and QoQ. Inflation rates seem to be tamed enough that the Fed may not increase interest rates further. Thus, someone might argue that STWD’s distributable earnings in the upcoming quarters may be high enough to cover quarterly dividends of $0.48 by the end of the year, implying a dividend yield of 11%. However, due to the USD depreciation against EUR, GBP, and AUD in the past 6 weeks, the ongoing concerns about the collapse of a few U.S. banks that caused depositors to move their money to money market funds, STWD’s financial results may impair further in 2Q 2023. Also, it is important to know that the effect of hiked interest rates on STWD’s interest expenses is more significant that its effect on the company’s interest revenues. Thus, as long as the interest rates are high, Starwood Property may gut hurt more. Thus, despite the company’s high dividend yield, the market condition is not favorable and the financial risks are high enough that a buy rating based on the company’s high dividend yield may not be justified. STWD is a hold.

Financial results

In the first quarter of 2023, Starwood Property Trust reported a total revenue of $490 million , compared with $294 million in 1Q 2022 and $455 million in 4Q 2022. In 1Q 2023, interest income from loans of $431 million, accounted for 88% of STWD’s total revenue, compared with 80% in 1Q 2022 and 87% in 4Q 2022. Also, it is important to know that in 1Q 2023, 84% of STWD’s total revenue was linked to the Commercial and Residential Lending segment, compared with 76% in 1Q 2022 and 83% in 4Q 2022. It means that analyzing the company’s operating results in the Commercial and Residential Lending segment says a lot about Starwood Property Trust.

In 1Q 2023, in the Commercial and Residential Lending segment, STWD generated $410 million of revenue, $145 million of net income, and $192 million of distributable earnings on $21 billion of assets. In 4Q 2022, in the Commercial and Residential Lending segment, STWD generated $376 million of revenue, $115 million of net income, and $171 million of distributable earnings on $21 billion of assets. Finally, in 1Q 2022, in the Commercial and Residential Lending segment, STWD generated $225 million of revenue, $209 million of net income, and $231 million of distributable earnings on $18 billion of assets. We can see that in the past year, how STWD’s financial results were negatively affected by high interest rates, high inflation rates, and low economic growth.

In 1Q 2023, interest expense of $335 million accounted for 70% of STWD’s total costs and expenses, compared with 52% in 1Q 2022 and 69% in 4Q 2022. The Commercial and Residential Lending segment accounted for 56% of STWD’s total costs and expenses, compared with 32% in 1Q 2022 and 57% in 4Q 2022. In the first quarter of 2022, Starwood reported a credit loss reversal of $3 million, which was linked to the Commercial and Residential Lending segment. However, this credit loss reversal in the mentioned segment, turned into a credit loss provision of $27 million in 4Q 2022 and increased to $31 million in 1Q 2023. Overall, the company’s interest income (from loans and investment securities) increased 82% YoY and 9% QoQ. On the other hand, its interest expense increased 165% YoY and 13% QoQ. These numbers mean that as a result of hiked interest rates, Starwood’s interest expenses increased significantly more than its interest income, implying that high interest rates are not favorable for the company. Also, the increasing amount of credit loss provision show that the economic slowdown, high inflation rates, and high interest rates have hurt Starwood’s income in a significant way.

The company’s net income (before income taxes) decreased from $382 million in 1Q 2022 to $157 million in 4Q 2022 and decreased further to $51 million in 1Q 2023. It is important to know that a large part of STWD’s net income is linked to its other income. Excluding other income, STWD’s income (before income taxes) decreased from $50 million in 1Q 2022 to $24 million in 4Q 2022 and decreased further to $5 million in 1Q 2023.

STWD’s significant other income

As the company’s other income elements play a significant role in its financial results, let’s take a look at them. In the first quarter of 2023, STWD’s foreign currency gain was $15 million, compared with $116 million in 4Q 2022, and a foreign currency loss of $27 million in 1Q 2022. Figure 1 shows STWD’s commercial portfolio geographic diversification as of 31 March 2023. According to the company’s financial results in 1Q 2022, 4Q 2022, and 1Q 2023, about 99% of the company’s foreign currency gains and losses are connected to its commercial portfolio. Figure 2 shows USD against EUR, GBP, and AUD in the past two years. As USD appreciated against other currencies in the fourth quarter of 2022, Starwood Property’s foreign currency gain jumped. In the first quarter of 2023, USD depreciated against EUR, GBP, and AUD. Thus, the company’s foreign currency gain decreased. USD exchange rate against EUR, GBP, and AUD decreased further in the past 6 weeks, implying that STWD’s foreign currency gain in 2Q 2023 may be lower than in 1Q 2023. With the current global economic condition, I don’t expect USD/EUR, USD/GBP. And USD/AUD to drop to their levels in the first quarter of 2022 in the following months. Thus, I don’t see the company’s foreign currency gain turning into a foreign currency loss in the upcoming quarters. However, the company’s foreign currency gain in 2Q 2023, 3Q 2023, and 4Q 2023 may be about $10 million, which is far lower than in 4Q 2022, and also lower than in the previous quarter.

Figure 1 - STWD’s commercial portfolio geographic diversification

Figure 2 – USD against EUR, GBP, and AUD

Also, in 1Q 2023, STWD’s income from affordable housing fund investments was only $13 million, compared with $97 million in 4Q 2022 and $234 million in 1Q 2022. Moreover, the company’s gain on the sale of investments and other assets dropped from $98 million in 1Q 2022 to $23 million in 4Q 2022 and plunged to less than $1 million in 1Q 2023. Furthermore, STWD’s gain on derivative financial instruments of $127 million in 1Q 2022 turned into a loss in 4Q 2022 and 1Q 2023. Due to these changes, STWD’s distributable earnings dropped from $240 million ($0.76 per diluted share) in 1Q 2022 to $161 million ($0.50 per diluted share) in 4Q 2022, and $157 million ($0.49 per diluted share) in 1Q 2023.

Dividend yield

Someone might argue that despite all of these facts, STWD still has a high dividend yield. In the first quarter of 2022, the company paid a dividend of $0.48 per share, flat YoY and QoQ. But it is important to know that STWD’s distributable earnings per weighted average diluted share dropped from 1Q 2022 to 4Q 2022, and decreased further in 1Q 2023. As a result of higher interest rates in the second quarter of 2023, low economic growth, and still relatively high inflation rates, I don’t expect the company’s 2Q 2023 net income and distributable earnings to be higher than in 1Q 2023. If the company could be able to pay quarterly dividends of $0.48 per share in 2Q 2023, 3Q 2023, and 4Q 2023, at its current stock price, its dividend yield is estimated to be about 11%, which is an attractive dividend yield. However, with the continuation of high interest rates, inflation rates of more than 2-3%, and low economic growth, Starwood Property’s income, and distributable earnings may impair further.

On 3 May 2023, the Fed raised rates by 0.25% for the tenth consecutive time to the range of 5.0% to 5.25%. Inflation rates decreased significantly in the past few months, and higher interest rates can cause serious financial instability in the United States. Thus, higher interest rates are not likely. However, we cannot expect the rates to decrease soon. I think interest rate cuts might start in the first half of 2024. However, if inflation rates decrease faster than expected in the following months, the Fed might consider slight interest rate decreases in the last quarter of 2023.

Infrastructure segment

Due to the not favorable market conditions for the Commercial and Residential segment in the past few quarters, Starwood Property increased its investments in the Infrastructure Lending segment. In the first quarter of 2023, the company’s new investing was concentrated in infrastructure lending, which accounted for 73% of STWD’s new origination activity. Starwood Property’s interest income from loans in the Infrastructure Lending segment increased by 104% YoY and 10% QoQ to $55 million in 1Q 2023. However, its interest expense in the Infrastructure segment increased by 175% YoY and 10% QoQ to $33 million in the first quarter of 2023. The company’s net income in the Infrastructure segment in 1Q 2023 was lower than in 1Q 2022 and 4Q 2022.

Starwood Property’s distributable earnings in 1Q 2023 were higher than in 1Q 2022 and 4Q 2023. However, it is important to know that it was due to the positive effect of adding the credit loss provision of $12 million to the net income in the Infrastructure segment. In 1Q 2022 and 4Q 2022, the company reported a credit loss reversal of less than $1 million. These numbers imply that increased investment in the Infrastructure segment was not immune to the not favorable market condition driven by low economic growth and high interest rates. Thus, the company’s investments in the Infrastructure segment may not be able to increase Starwood Property’s net income.

Summary

Starwood Property’s stock price decreased considerably in the past few months. The company was able to pay a dividend of $0.48 per share in 1Q 2023 and may be able to continue paying this amount of dividend in the upcoming quarters. However, STWD’s financial results in 2Q, 3Q, and 4Q 2023 can be weaker than in the first quarter, terminating the company’s ability to maintain its quarterly dividend of $0.48 per share. Also, due to potential financial instability and low economic growth, the stock’s price can decrease further, and not recover for a long time. The stock is a hold.

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