Mortgage real estate investment trusts, or mREITs, have been a tough investment in this rate environment. One name that has held up in the space is Ellington Financial Inc. (NYSE:EFC), and it is well positioned for when rates normalize and the housing industry rebounds, in our opinion.
We still like income names to comprise about 20% of your long-term portfolio. Within those long-term income holdings, we endorse having dividend paying names, blended with dividend growth, and/or high-yield. Now we got some bad news in the form of a dividend reduction from $0.15 monthly down to $0.13 monthly, which is still good for a 13% yield. Moreover, those reinvesting their dividends are building a massive income generating potential for the long term. While the principal value fluctuates, even if the position is down on paper, you have not lost anything if you have not sold. That said, we still rate shares a buy here, and we will discuss the recent results.
Ellington’s portfolio has income from several sources, and the underlying is diversification pays off. Income is generated from a number of sources, and these include collateralized loan obligations aka CLOs, commercial MBS, non-Agency residential MBS, credit risk transfers, and more. This diversification has insulated the portfolio returns somewhat from the volatile rate space, but it is not immune.
In the recent earnings release, CEO Laurence Penn summed up the portfolio’s robust nature:
Steady performance from our non-QM and residential transition loan businesses, together with strong returns from our secondary CLO, CMBS, and non-Agency RMBS portfolios, drove Ellington Financial’s first quarter results
This is a great overview. Now the company actively manages its holdings, which we also like. Sometimes the market can go against the moves, but the flexible nature of the portfolio allows moves to be made to adjust to all climates. Penn added:
We also achieved some key portfolio objectives during the quarter. First, we successfully completed our inaugural securitization of proprietary reverse mortgage loans from Longbridge, thereby converting repo financing into term, non-mark-to-market financing at attractive terms. We expect that this securitization marks the beginning of an ongoing program for our proprietary reverse mortgage business, similar to the program we have established in our non-QM businesses. Second, we continued to cull lower-yielding securities from our portfolio, selling Agency and non-Agency RMBS and CMBS in order to free up capital for higher yielding opportunities. The culling of these securities, which are generally financed with higher leverage, drove down our overall leverage ratios, despite the capital deployment mentioned above.
So these moves are being done to generate more returns while also reducing leverage. While earnings and income available for distribution have been pressured for a number of quarters, and this led to a recent dividend cut following merger and acquisition activity, we still see the company’s performance as strong. We continue to keep an eye on leverage as it is a risk, the company has funds to make additional moves. But let’s look at recent income numbers.
In the most recent report, Ellington reported net income of $26.9 million, or $0.32 per common share. Making some adjustments, the adjusted distributable earnings (a measure of dividend coverage) were $23.7 million, or $0.28 per share. It is important to note a few things.
First, the share count is higher, dragging down the per-share results.
Second, even at the new $0.13 monthly payout, this result means that the dividend as paid is not covered by this figure. That is something that gives us pause. We had believed the dividend would be preserved, but there has to be earnings and cashflow to cover the payout, and we did not have this in recent quarters, hence the cut.
Still great income, no one likes a cut in their pay, but these guys will figure it out, and we believe they can ramp distributable earnings back up. This was also addressed by Penn:
We continue to work hard to get more fully invested in our higher-yielding strategies, drive origination profits at Longbridge, and work through the few sub-performing loans in our commercial bridge loan portfolio, as we build back up Adjusted Distributable Earnings. We continue to be patient..
So, as we know, the company picked up Longbridge Financial a year ago, and it is contributing. We also have the Arlington Asset Investment Corp acquisition which closed. The company has a good amount of uninvested capital held at year-end following the closing of the Arlington merger, but is deploying it strategically and patiently. The overall credit portfolio grew sequentially during the first quarter, with growth from CLO purchases. A look under the hood shows they expanded their commercial mortgage bridge loan portfolio. This section of the port had been a drag for over a year, with prepayments outpacing new originations quarter after quarter. We like to consider mREITs trading at sizable discounts-to-book.
The book value per common share was $13.69 At this level, you are getting a $1.52 discount-to-book, or a near 11.1% discount.
Final thoughts on EFC stock here
It never really seems to be an easy environment for mREITs, but we think slow managed rate cuts will create a benefit. Housing and commercial real estate should start to rebound, and this will lead to more originations. So long as rate cuts are not sharp and quick, the company can manage its portfolio effectively with its flexibility. In the last few quarters we have had a bit of a more stable environment, which is a benefit.
If you are investing here for income, try not to obsess over every quarterly report. Ellington Financial Inc. has taken steps to grow and emerge from this high rate environment stronger. We will be watching for a ramp up in distributable earnings. Book value has been strong. We think income-thirsty investors can consider buying on weakness here for income.
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