DYNEX CAPITAL INC DX
February 17, 2009 - 5:26pm EST by
bruin821
2009 2010
Price: 7.07 EPS N/A N/A
Shares Out. (in M): 12 P/E N/A N/A
Market Cap (in $M): 86 P/FCF N/A N/A
Net Debt (in $M): 475 EBIT 0 0
TEV ($): 561 TEV/EBIT N/A N/A

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Description

 

As Congress nears the passage of the stimulus bill and other housing subsidies are being debated, we believe mortgage REITS are well positioned to capitalize on this new dynamic in the housing market.  In the increasingly attractive m-REIT space, DX has one of the strongest risk / reward profiles. Given very wide financing spreads, the ability to expand its balance sheet (DX is levered at only 3x compared to the industry average of 8x - 10x), a largely untapped $1B shelf registration and strong counterparty relationships, DX is well suited to grow its TBV, EPS and raise its already handsome dividend pay-out to investors.

 DX (no institutional coverage yet) is trading at .95x TBV compared to peers which consistently trade at a 1.10x to 1.25x premium to TBV (see comp table below).

If DX were to be valued at P/TBV in the range of its peers, it implies a $8.00 - $9.06 stock price or 14% to 30% appreciation from here based on its current TBV of $7.25, which should increase substantially over time.  Additionally, DX rewards investors with a 13.1% dividend yield while they wait for positive events, already set in motion, to unfold. 

 Comp Table:

Ticker:  Price:    Mkt Value:      Price to TBV:      Mk to Mkt TBV (est)

NLY     $15.70      8,557                1.20x                     $13.15

HTS      $24.50         810                1.25x                     $19.85                 

MFA     $  5.80     1,260                 1.10x                     $ 5.40

ANH     $  6.30         560                1.12x                     $ 5.65

DX        $  7.00         90                 .95x                      $ 7.25

 

DX is run by owner-operators, the CEO is the largest shareholder and collectively the Board owns 22% of the company.   These owner/operators have a great track record of very disciplined risk management evidenced by their willingness to sit in cash through the end of 2007 waiting for an opportune time to invest their capital.   With the FED signaling a steep yield curve and low financing costs for the considerable future, DX can deploy capital at double digit ROI's on low risk Agency RMBS paper (government backed) and is currently raising capital from their warehouse lines to take advantage of these favorable opportunities.

 While the M-REIT space is especially attractive right now due to wide financing spreads, we think DX is uniquely situated to benefit from :

 

        (1) Management teams experience and conservative strategy

        (2) Ability to scale business via raising financing

        (3) $150m NOL that will shield future earnings and allow them to maximize the dividend to shareholders

        (4) Cheaper than most / all of its peers based on P / TBV, (the most cited industry valuation metric).

 Management Team:

 What helps us sleep well at night is the conservative nature of the management team and their philosophy toward risk management.  Historically, management has shown a tremendous amount of focus on risk management as they skillfully navigated the difficult mortgage market environment of 2008.  The two main decision makers are Tom Akin, the CEO and Byron Boston, the CIO.  They each have about 30+ yrs experience of committing capital into the markets. Tom became Chairman of the company in 2003 and redirected the company toward building a long term business model.  From 2003 to 2004 DX delevered its balance sheet, retaining only the most seasoned, best performing assets. Tom had the foresight to not chase yield (as everyone else was) and eschewed highly levered products that were the norm from 2004 - 2006.  The upside from their smart decisions and conservative nature is DX has a strong balance sheet to put capital to work at very accretive ROI's.   

 

Ability to scale:

 As stated above, DX has an under-levered balance sheet that presents an opportunity to scale the business.  Levered only 3:1, their stated goal is to increase their leverage to between 6:1 to 8:1.  Due to DX's conservative investment philosophy and strong relationships, they virtually added all counterparties after the Bear Sterns blow-up in 2008, despite the ensuing market volatility.  Currently, DX has 10 counterparties at an average amount of $30m, but is looking to scale to $50 - $100m in borrowings per counterparty, as well as add 2 to 5 more relationships.  They have stated that they will increase these warehouse lines slowly and prudently, as opportunities to deploy the capital at solid ROIs are presented.

 Additionally, DX has a $1B shelf registration in place. According to management, DX is looking to raise equity capital when the time is right.  For most stocks, dilution usually is viewed as a clear negative, but in the m-REIT industry this is known as a "virtuous cycle."  DX's goal is to raise equity capital above book value, lever it, put it to work at favorable ROIs and, thus further increase book value. As the share price appreciates because of the appreciating book value, they repeat this process creating additional value for shareholders. Hatteras Financial (HTS) is a good example of how raising equity for a m-REIT can help the share price, as they raised approximately $180m on Dec 10th, and the stock is up 20%+ since the capital raise.

 For DX, issuing more equity will also have the dual effect of increasing liquidity, which should help close the valuation gap to both TBV and its peers.

 

Breakdown of DX's current Investment Portfolio:

 

Securitized loan portfolio: (legacy loans, vintage '93 - '97)

Single family mortgages:                              $77.4m

Commercial Mortgages:                              $177.9m

 

RMBS loans:

RMBS Agencies (2007/8 vintages)               $301m

Other: (equity securities, joint venture, etc)    $25m

 

Total investment portfolio:                           $580m (as of 09/30/08)

 

Essentially DX has two tranches of investments, its legacy portfolio from the mid 1990's and RMBS Agency portfolio. Further explanation of each is below.

 

Legacy investments:

DX has a well seasoned legacy portfolio which consists of $77.4m in single family residential mortgages and $177.9m in its commercial mortgage bonds.  The majority of these have vintages between 1993 and 1995.  Currently, they are throwing off plenty of cash flows to help support the dividend. Their credit metrics are favorable and management estimates they have a 47% average LTV (loan to value ratio) as the mortgage holders have been paying them down for 13+ yrs.  Given their high quality and extensive seasoning, loss performance has historically been excellent.  Additionally, there is some potential upside opportunity for a few of these bonds, as some are callable (and should be worth par value).  Currently, DX carries them on the books at an $8m discount to par, so if called, DX would realize a .65c pre-tax gain.

 RMBS:

The Company's agency mortgage-backed securities are collateralized by single-family mortgage loans, which the payment of principal and interest has been guaranteed by Fannie Mae or Freddie Mac.  The Company's Agency RMBS are comprised primarily of hybrid RMBS, which have interest rates that are fixed for a specified period and reset annually thereafter.  As of September 30, 2008, the Company's Hybrid Agency RMBS securities were $301m, up from $7m at the end of 2007 and $139m at the end of the June 30, 2008 quarter.

 

In the current interest rate environment, DX is able to get 150 to 225 bps net financing spreads on short duration, high quality Agency RMBS.  This translates into ROI's in the mid teens range.  REPO conditions continue to improve.  DX's cost of financing on its warehouse lines are based off 1 month LIBOR + a spread.  Thirty day LIBOR is 44 bps as of Feb 3rd verse its average coupon on the RMBS paper at approximately 5%.  Even if, as expected, average coupon rates fall in 2009, the net spreads will continue to be very favorable by historical standards and the agency trade should maintain double digit ROIC.

 

Federal Government Intervention:

It's likely the Fed government's plan on stimulating the housing market, either through the use of tax credits or special low mortgage rates will benefit the m-REIT space.  Regardless of which form of the housing market subsidy passes, the pressure from Washington on banks to lend and the trend for global liquidity investors to look for hard assets like agency MBS backing their short term investments will certainly keep down financing costs for m-REITS.  Additionally, back in November, the FED decided it would buy $500B of agency MBS (of which only 15% has been completed), thus continuing to increase liquidity.

 RMBS prepayment risk:

DX's strategy is to acquire short duration mortgages in order to manage the portfolio for prepayment risk.  The Agency RMBS portfolio has average resets of just over 20 months to maturity.  Their plan is to continue to stick with short maturities to mitigate anticipated faster prepayment speeds because of the potential for increased REFIs.  Management claims that they have factored faster prepayment speeds into its own internal analysis and they still believe they will grow EPS meaningfully, as they are able to reinvest any REFI proceeds at double digit ROIs.  While we can't predict if REFIs will speed up or not for DX, the number of potential REFIs are somewhat mitigated based on the lack of equity so many homeowners have in their homes and the current job environment.    Also, while some M-REITs buy longer dated maturity RMBS assets and therefore use interest rate swaps to hedge risk, DX does not need to use swaps.  Therefore, DX should outperform on its cost of borrowings vs. its peers that use swaps.

Capital structure:

There are 12.2m common shares outstanding and 4.2m convertible preferred shares (Ticker: DXD) convert at $10 that have a 9.5% coupon.  Fully diluted s/o, including options, is 16.4m. 

 NOL

DX has a $150m book NOL that will shield profits and allow management to maximize the dividend.  The NOL doesn't begin to expire until 2019.  Additionally, in keeping with their true conservative fashion, they are not carrying any tax asset with regard to the NOL on their balance sheet, so if profitability continues, true book value is somewhat understated.

 Risks:

  • (1) Prepayment risks on its Agency portfolio as interest rates decrease and mortgage holders refinance.
  • (2) Credit markets freeze (again) and their borrowing costs increase for extended period. - Note that Management successfully navigated the difficult mortgage markets in 2008 (1 mo LIBOR rose up to 3%+ and DX still managed to increase EPS and the dividend substantially.)

Catalyst

 

Catalysts:

  • (1) Increasing dividends as profitability continues to rise as they put more capital to work
  • (2) Potential institutional coverage
  • (3) Increase in liquidity of the stock as the $1B shelf is accessed.
  • (4) Cheap, trading below TBV vs. peers trading at premium to TBV. Book value, is understated because of large NOL and should increase; Also, they will likely have a "write-up" of assets that were previously written down for accounting purposes.

 

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