Thesis and background
Since I first published my bearish thesis on Orchid Island Capital (ORC) on Aug 8, 2020, the stock has lost 14.9% of its price while the overall market advanced about 5%. And the dividend yield has maintained at 15.6% due to such a sizable price drop even when it had to cut its dividend by 15%. Announced on Jan 13, 2021, its monthly cash dividend will go to $0.055 per share of common stock, down 15% from the prior dividend of $0.065.
With a 15%+ dividend yield, ORC may appear attractive to many income-oriented investors, especially under a low-rate environment. Moreover, you may be wondering if the investment has become safer because of the price drop.
Indeed, the investment risks in a given stock decrease as its price drops – but only when the fundamentals stay the same – a critical caveat. The thesis of this article is that it is not the case with ORC. Even though its price has dropped substantially since my last writing, its fundamentals have also deteriorated in the meantime. As a result, the risks remained high. And we will examine the following risks one by one in detail in the remainder of this article:
- Low and inconsistent profitability despite high leverage
- Valuation risks
- Risks to afford its current dividends
Low and inconsistent profitability despite high leverage
As detailed in my earlier article,
For a financial business like ORC, there are two knobs that management can turn to drive up profitability: return on asset (“ROA”) and leverage. Through simple math, we can show that ROE is just the product of these two things, i.e.,
ROE = ROA x leverage.
Where ROA here is defined as net income divided by total asset and leverage is defined as total asset divided by share equity. ROA shows how efficiently the management is working the asset to generate earnings. And leverage is just leverage – it magnifies earnings in good times and magnifies losses in bad times.
As we will see next, ORC has unfortunately been doing a poor job turning both knobs. And as you can see from the following chart, its return on equity (“ROE”) has been inconsistent with a meager average of 0.7%. To put things under perspective, a 10% ROE is typically considered the gold standard for financial institutions. And ORC’s ROE is nowhere near. More importantly, and more alarmingly, its leverage is significantly higher than the sector average at the same time.
The following chart shows the ROA, the first ROE knob, for ORC. As seen, ORC’s ROA has also been inconsistent and low, with a historical average of 0.1%. Again, to put things under perspective, a 1% ORA is typically considered the gold standard for financial institutions. And ORC is again nowhere near this mark.
Lastly and more alarmingly, ORC’s poor profitability persisted despite its employment of higher leverage. The next chart shows its leverage. As seen, ORC’s leverage has been on average 8.9x in the past decade, and its current leverage is on par with the historical average.
To put things under perspective, the average leverage ratio for the mREIT sector is about 6.6x only. As a result, ORC’s leverage is 34% higher than the sector average. A substantial amount that makes it a lot riskier than the sector, especially with the unfolding interest rate hikes according to the latest dot-plot announced by the Fed. And we will detail the interest risks later at the end of this article.
Chronic loss of tangible book value
ORC has also suffered a chronic loss of tangible book values (“TBV”), a red flag for mREIT business. As shown in the following chart, it has been losing its TBV at an alarming rate, 12% CAGR since 2012, making it kind of an annuity – with a bad leak – for shareholders.
During the 2020 COVID pandemic, ORC – like all the other mREIT players – had to react by liquidating its mortgage-backed securities and shrinking the size of its balance sheet. The liquidation shrank the TBV per share from $6.27 to $5.46 per share, a 12.9% decrease. However, what is really concerning here are that A) such decrease is chronic in ORC’s case, and B) many other mREITs have recovered their TBV losses from the pandemic by now, but ORC did not.
So in ORC’s case, the pandemic is not the cause for its TBV losses – it just accelerated it.
Despite all the above issues, ORC’s valuation is not cheap by historical standard. As seen in the next chart, ORC’s current valuation is around 0.96x of its book value. This level of valuation is not only on par with other safer more profitable stocks in the mREIT sector, it is also at a high level relative to its own historical record. As seen below, ORC has been historically valued at an average of .8 times its book value and the current valuation is a substantial 20% premium above its historical average.
Interest risks and dividend coverage
As mentioned at the beginning, ORC has a higher than average leverage ratio, which makes it more exposed to the interest rate risks. ORC makes its money on the spread between the long-term and short-term rates. ORC’s current short-term debt is about $5.2B. Based on these financials, the picture for its interest coverage and dividend coverage is quite bleak ahead. Let’s just consider a few simple numbers:
- Its TTM operation cash flow is about $86M and its net profit is in the negative.
- It will need about $73M of cash per year just to maintain its current Common & Preferred Stock Dividends. Going forward, it will need about $62M per year to maintain its reduced dividends of $0.055 per share per month.
- With its current borrowing, a 1% increase in its interest rate would translate into $52M of additional interest expenses.
So the bottom line is that it already is having trouble covering its debt and dividends at the currently also zero borrowing rate. And a 1% interest rates rise would force it to cut dividends, or even worse, make it permanently unprofitable.
Finally, the interest raise could be more than 1%. The Fed’s most recent dot-plot hints a raise of the fed fund rates to about 1% in this year and another 1% in the next one or two years.
Conclusion and final thoughts
Since my last bearish thesis on ORC in Aug 2020, the stock has lost almost 15% of its price and the dividend yield has surged to 15.6%. In case you are wondering if it has become safer now or feel attracted to the 15%+ yield, you need to be aware of the following potential dangers:
1. The stock suffers low and inconsistent profitability despite its high leverage ratio (more than 1/3 higher than the sector average).
2. Its higher leverage ratio makes it more exposed to the interest rate risks. It already is having trouble covering its debt and dividends at the currently almost zero borrowing rate. And even a 1% interest rates rise would force it to cut dividends, or even worse, make it permanently unprofitable.
3. It has suffered a chronic loss of tangible book values – at an alarming rate of 12% CAGR since 2012. With such chronic losses, it is equivalent to an annuity – with a bad leak – for shareholders.
4. Lastly, despite all the above problems, its valuation is actually at a premium compared to its historical average.
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