Luminent Mortgage Capital, Inc. is a real estate investment trust that invests in U.S. agency and other high-rated mortgage-backed securities. LUM generates income from the spread between the interest income on its mortgage portfolio and the borrowing costs of acquiring the mortgage portfolio. Luminent is different from its peers in that it invests in agency MBS and AAA mortgage securities. The company invests in the AAA’s because they yield 15-30 basis points more than comparable agencies, and they allow LUM to diversify its portfolio.
LUM recently has also begun to expand its operations from being a solely spread business - the company now plans to start investing in whole loan pools and credit sensitive bonds. LUM plans to underwrite its own loans as well as acquire them from third parties. The company will securitize the pools of loans and retain them on their balance sheet, earning interest income. Recently LUM has been under earnings pressure due to the flattening of the yield curve. However, this is only a temporary condition with an end in sight. When the fed stops raising interest rates earnings start to go up because there is a lag between the repricing of their funding costs and their assets. Thus, if the fed stops, their funding costs remain constant immediately while their mortgage assets will still continue to yield higher for another 12-14 months. This is because their morgage assets reprice only once a year so only 1/12th of their assets reprice per month. The following are earnings and dividend estimates relative to the fed stopping to raise interest rates:
If the Fed were to stop raising short term rates at 4.5% by the end of January, and keep it at 4.5%, in 2Q06 LUM’s net margin would begin to increase. By the end of 1Q07, it would be 87bps, providing $.39 in earnings and $.38 in dividends for the quarter. The trend of expansion will continue throughout the year. In the second, third, and fourth quarters the margin would increase to .95%, 1.02%, and 1.09% respectively, providing for earnings of $.42, $.45, and $.49 for the respective quarters. This will supply dividends of $.42, $.45, and $.49 for the second, third, and fourth quarters. By the end of 2007 LUM will have earned $1.76 and distributed $1.76 in dividends. This represents a 22.9% dividend yield for the stock based upon today’s stock price, and a 13.9% ROE.
With a terminal fed funds rate of 4.75% by the end of March 2006 and no change from there on, margins would gain traction in the third quarter of the year. By the end of 1Q07 margin spread would be .47% resulting in $.24 in earnings and $.24 in dividend for the quarter. Continuing on into the year, the margin would increase to 0.56%, 0.64%, and 0.72% in the following three quarters giving earnings of $0.26, $0.28, and $0.30 per respective quarter. Dividend distributions would be $0.26, $0.29, and $0.31 for the 2nd, 3rd and 4th quarters since LUM distributes all earnings via dividend barring small diferrences between taxable and gaap earnings. With the Fed stopping at 4.75 at the end of March, LUM could expect to see earnings for 2007 of $1.07 and dividend of $1.10. Although lower than the 4.5% scenario, this would still represent a 14.3% dividend yield on todays stock price and a 9.4% ROE.
In the case that the Fed tightens all the way through May to 5% and then stays there, LUM would regain positive margin momentum in 4Q06. 1Q07 would see them with a net spread of .22% earning $.19 and distributing $.19 in dividends. For the remainder of the year net spread would continue to expand to 0.30%, 0.38%, and 0.46% in the following three quarters. With earnings being $0.21, $0.23, and $0.25 for the second, third and fourth quarters and dividends estimated at $0.21, $0.23, $0.26 for the same period, LUM would end the year at $0.87 in earnings and $0.90 in dividends in this scenario. This would represent a 11.7% dividend yield and 7.7% ROE, with still continued earnings and dividend momentum in 2008.
The above earnings scenarios show possible results depending on Fed target rates. However, the important thing to note is that in all three scenarios the company will begin to expand margins at a fairly significant pace, the expansion timing is simply dependent on when the Fed stops.
Recently, management has announced that they will be buying back 2 million shares of stock at a time when shares are trading below book – this should bode very well for shareholder value.
Luminent has an approximate $10.74 book value per share as of 2Q05. The stock currently trades at $7.66, representing a 40% upside if the stock only returns to book value. This represents sufficient value for a stock that is depressed due to margin concerns which should alleviate in the near future.