Ellington Residential: Horrific Market But Dividend Looks Good (NYSE:EARN)

Ellington Residential Mortgage REIT (NYSE:EARN) is a mortgage real estate investment trust, or mREIT that we used to trade years ago. We were recently asked about this company and its operations, as well as our opinion, following recent coverage of similar types of companies. This company experienced a lot of pain during COVID and really never fully got out of the pain, though things are much better now. They are back in business. As an mREIT, the action the Federal Reserve has taken the last few months has weighed heavily. In fact the Feds super aggressive response to high inflation continued to drive markets in Q2 but especially weighed on real estate, and companies like this that buy and sell mortgages and bundles of mortgages. It just is tough when The Fed twice increased its target rate for the federal funds rate, including a 75 basis point hike in June. Let us not forget it has been selling off its holdings in treasuries and mortgage backed securities, or MBS balance sheet items. EARN stock has gotten hit hard recently, like many other mREITs.

Recent performance hammered by volatile rates

Now, the company just reported earnings, and the pain is obvious. But you have to take it with a grain of salt, because while Q3 will likely be just as tough, the situation should improve in 2023 in terms of stability. In Q2 we saw interest rates continued to surge and the interest rate volatility spiked to levels not seen since the onset of the COVID liquidity crisis in early 2020 and before that the fiscal crisis of 2008-2009. In Q2 we saw liquidity dry up some and yield spreads widened, but prices fell across most fixed income sectors, including agency RMBS. That hurt. As we will see, these movements hurt many of the key metrics we watch. Of paramount concern is the dividend coverage, however. A summary of the critical metrics that you should be aware of for Ellington Residential Mortgage is shown below for Q2 2022:

Key Metric	Most Recent Data*
Q2 2022 book value and % change from Q1 2022	$9.07(-10.5%)
Net interest rate spread in Q2 2022	1.66%
Current dividend quarterly (yield)	$0.24 (11.2%)
Q2 2022 Net income (loss) per share	($0.82)
Q2 2022 distributable income per share	$0.28
Dividend covered?	Yes*
52-week share price range	$6.40-$12.44

Click to enlarge

Source: Ellington Residential Mortgage REIT’s Q2 2022 Results

Table created by BAD BEAT Investing

* As of 6/30/2022

** By distributable income

Dividend coverage is always the main concern

Follower of this company may remember that the dividend had been cut time and again with this firm in years past. To our surprise here in Q2 2022, as the $0.08 monthly payout, or $0.24 per quarter rate was well-covered. Net income was a big loss but we do not care so much about this measure for the dividend with an mREIT.

It was a tough space for a while and is still tough. But we think you can start buying here in Q3 as we expect the pace of rate hikes to slow into the end of the year.

What is most critical here is that the distributable income (formerly known as core income) exceeded the dividend significantly. That said, net interest margin and distributable earnings fell significantly quarter over quarter. These drops were driven by a volatile cost of funds, movement in asset yields, and lower pricing. It was tough. At the end of the day, this is still an income name, so that coverage matters. The distributable earnings are a solid gauge for dividend coverage, and EARN delivered despite a tough quarter for the sector.

There was a lot we did like this quarter, but a few negatives. On the earnings front, as mentioned, there were net losses. No surprise here. The company saw a net loss of $10.7 million, or a loss of $0.82 per share, compared to a loss of $1.23 per common share in Q1. But again, the better measure of the ability of the company to pay its dividend is its distributable earnings, and here we saw only a slight decline. Distributable earnings were $3.7 million or $0.28 per share. We thought it would be worse and thought a print of $0.24 could come in, covering dividend. This was sizable outperformance. That said, we need to watch this metric as we do not want another dividend cut for sure.

The drivers of the quarter were discussed by CEO Laurence Penn who stated:

Prices on Agency RMBS declined significantly, with the largest declines in lower coupon RMBS, which face heightened extension risk. For Ellington Residential, net losses on our specified pools, concentrated in low coupons, exceeded net gains on our interest rate hedges and net carry from the portfolio, which resulted in a significant overall net loss for the quarter. As with the preceding quarter, our interest rate hedging strategy… helped prevent further losses and limit our book value decline. On the positive side, wider yield spreads, while a drag on book value, have been a tailwind for distributable earnings… [these] covered our dividend for the quarter, as our net interest margin held up relatively well despite a rising cost of funds.

So while the macro situation was tough, the company weathered the storm, but the book value took a hit.

Book value suggests a sale

Believe it or not this stock is up nicely off recent lows a few months back, mostly with the market rally. We think you let it pull back some, but as of now, the stock is at a slight discount to last known book value. Given trends in Q3 we are likely trading at or very very near book value. Book value fell a dramatic 10.5%, to $9.07. So we have a $0.54 discount-to-book, or a 5.6% discount. In this volatile market, let the stock fall to at least a 10% discount again before buying. That is our advice, but we think the stock will enjoy a ramp up off the next low because we expect the mortgage backed securities pricing to stabilize into next year.

Final thoughts

Should the stock get crushed by a market selloff in the coming days or weeks, we suggest that you consider shares at a 10% discount to the last known book value or more. The yield is over 11% now, and will be higher if the stock falls, giving you some protection to the down side. Keep an eye on the distributable earnings for coverage.