2023-05-08 05:54:14 ET
Summary
- MFA reported mixed earnings, the NII was less than $40 million, a 38% decrease Y-o-Y.
- The management’s main focus was to stabilize its cost of funds and with its total of 12 securitizations, they achieved this goal.
- There is still some chance that the management has to cut the dividend further if the earnings do not improve soon.
Investment thesis
In my previous article about a year ago, I wrote about MFA Financial, Inc. ( MFA ) reverse stock split and warned investors about its potential further downside risk. Since then the stock fell by more than 22% and the management cut its dividend by 20% in December 2022. The external macroeconomic trends very slowly starting to shift to MFA’s favor with potentially no more interest rate increases. Despite some positive news, I am still wary of the stock in the upcoming quarters.
First Quarter Earnings
The company reported its first-quarter earnings on Star Wars Day, May, 4 th . They reported mixed earnings, the NII was slightly below $40 million, a 38% decrease Y-o-Y, and an EPS of $0.30, which missed the estimates by approximately 6%. The interest expense also grew by 6.4% Q-o-Q and almost tripled Y-o-Y. The NII was the lowest in the last 2 years due to aggressive interest rate hikes.
I expect that this interest expense growth trend is slowly going to fade away as the Fed stops raising the base rate and the inflation and mortgage rates are going to be under control. As the interest expense starts to moderate the NII will slowly rise, giving some breathing room to the management. In addition, I also expect that the market volatility investors experienced last year is not over yet.
During the first quarter of the year, MFA acquired approximately $630 million of loans and securities, increasing its portfolio by 6% to a total of around $8.4 billion at the end of the period. Due to the high-interest rates, expansive spreads, and the company’s capability to obtain loans, they have been presented with great opportunities for adding profitable loans to their portfolio which they did. During the quarter, MFA secured an additional $450 million in loan commitments, with a 10% average coupon rate and strong credit qualities thanks to its originator Lima One. The average Loan-to-Value ratio was 66%. In addition, MFA capitalized on the opportunity and conducted 3 securitizations. This was backed by a total of $668 million in loan assets. The management’s main focus was to stabilize its cost of funds, and with the 9 securitizations they managed in 2022 and their $3 billion interest rate swap book it seems that they achieved this goal by the end of Q1 2023. The cost of capital has risen by less than 0.6% in the last three quarters. At the same time, there has been a growth in yields of MFA’s purchased performing loan portfolio by approximately 1.2%, in the same period. Investors have seen a sharp rise in the yields of recent purchases, and that is likely to continue to expand MFA’s interest rate spread in the near future. The biggest risk to the portfolio is the credit risk. MFA's loan portfolio does carry a credit risk, as the loans are not backed by the U.S. government.
Valuation
As the management stated previously, there is an earnings issue with which I could not agree more. The lion’s share of the problem is the external macroeconomic environment and this is heavily affecting shareholders and MFA’s earnings potential. The price to tangible book value suggests that the stock is undervalued, it is trading at only 0.55x to its TBV. It is below its 3-year average and almost half of the sector median as well. The management continued its share buyback program and in the last 12 months, the average shares outstanding decreased by 11.3%.
Comparing MFA to an mREIT ETF such as iShares Mortgage Real Estate ETF ( REM ) we can see the difference. MFA is the 11 th largest holding of the REM ETF with a weighting of 2.6%. In the long-term MFA has been a better choice for investors based on total return than buying into an mREIT ETF.
Dividend
The management was among the first ones to partly restore its dividend after the pandemic shock and also started to increase it. However, the rapid interest rate increases and slowing economy put the management into a difficult situation and they had to cut the dividend. The market was more or less prepared for it because there was no sudden stock price drop after the announcement. Looking ahead, the management may have to further cut the dividend in the next quarters. The management made some statements in the third quarter of 2022 before they cut the dividend by 20%.
“We have bought over $100 million worth of stock back this year, and it hasn't helped a whole lot” Craig Knutson - President and CEO
“Current dividend level, we could pay that dividend for two and a half years with that cash. So it's not a, dividends are not a liquidity issue, it's more of an earnings issue.“ - Steve Yarad – CFO
They have made no comments about dividends in the last two quarters which means to me that their policy has not changed. If the earnings are not good enough they might further cut the dividend to allocate that cash somewhere else. According to my estimates, there is a 30-40% chance the management will cut the dividend in the next 12 months. Most analysts expect that MFA will maintain its current dividend while some expect that they will cut it further by 10-12% and none of the analysts expect a dividend increase. MFA is trading at approximately 13.6% dividend yield and if there is a 10% cut it will be trading around 12%. It is still not too bad but I would keep myself away from a management that needs to cut the dividend because earnings are dropping.
Final thoughts
The short-term pain for MFA shareholders will likely fade away in the future as the external macroeconomic environment changes in MFA’s favor. In my opinion, the company is not ideal for income-seeking investors but it has proven that it can outperform its mREIT peers and also has a stable loan portfolio. That is why my rating on MFA has not changed yet.
For further details see:
MFA Financial: The Pain Is Slowly Fading Away