Why This Dividend Cut Is a Good Thing

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Some investors have adopted a very short-term way of thinking in today's market. I personally prefer companies that are investing in their business for the long-term rather than trying to “buy” short-term profits. This is partially why I own shares in Hatteras Financial Corp. (NYSE: HTS). Hatteras is a mortgage real estate investment trust, but the company specializes in adjustable rate loans instead of the 30 year variety that many mREITs invest in. The company's shares recently took a hit based on a dividend cut, but for long-term investors this “cut” is a good thing.

Hatteras management essentially said that they weren't going to “reach for results” and that the dividend being lowered from $0.90 per share to $0.80 per share was an adjustment that was necessary. Though this decision hurts the current yield, smart investors should be buying Hatteras for what the company will offer, rather than looking in the rearview mirror. One part of understanding Hatteras is getting comfortable with the fact that an mREIT really never “cuts” or “raises” its dividend. These companies pay a percentage of earnings, so in theory their dividend should change frequently. These are not companies like your Procter & Gamble, Coca-Cola, or others where a dividend cut is a big deal and breaks a pattern. With mREITs, investors need to keep their eye on the horizon for what the company will do in the future, rather than what they have already done.

Hatteras' investors should be pleased with what the company can offer going forward. In fact, of several popular mREITs, Hatteras might offer the best combination of future yield and future growth. Competition in the field is fierce with companies like Annaly Capital (NYSE: NLY), Chimera (NYSE: CIM), and Invesco Mortgage Capital (NYSE: IVR) all going after some piece of Hatteras' business. What makes Hatteras unique is that they focus mainly on adjustable rate securities. Annaly and Chimera invest in similar fashion, but Annaly buys agency securities, and Chimera focuses on the non-agency side of the business. Invesco is an interesting hybrid that invests in multiple different types of both fixed and adjustable securities that can be either agency or non-agency type. While each of these investing styles offers different advantages and disadvantages, there is no getting around the fact that Hatteras' greatest current weakness might be the company's biggest advantage in the future.

Investors need to realize right away that Hatteras' average coupon and interest spread will always be lower than their competition. The reason is that adjustable securities carry lower rates. After all, why would a homeowner choose an adjustable mortgage if they didn't get a lower rate? With mortgage rates as low as they have been in decades, this is cutting into Hatteras' interest margin as customers with adjustable rate loans can refinance to very low fixed rate loans. In addition, when some of these loans reset they are adjusting to lower rates, rather than higher rates like in the past. This compressing yield is being offset by the fact that Hatteras can use leverage to grow its balance sheet. This is why in the current quarter net income was up 3.8% year-over-year, but EPS was down because of a near 30% increase in outstanding shares. That being said, the company's book value is now $29.60 per share compared to the $25.47 the shares currently trade at. In addition, Hatteras is making some smart moves to benefit investors in the future.

With the housing market on the mend, in theory it's only a matter of time before unemployment improves and short-term rates need to rise. However, Hatteras has locked in a fixed rate of about 1.48% on its swaps over the next 34 months. This gives the company a fixed rate to use when choosing its investments. The company's average coupon is 2.99% so as you can see the spread isn't much, but management is making the most of the current market. Other mREITs use similar strategies, but there is no getting around the simple fact that when rates rise, adjustable rates move first. The fact that Hatteras has most of its adjustable rate securities due to adjust between 24 and 84 months is no coincidence.

What should happen is, within the next two years the housing market and unemployment picture should continue to improve. If that occurs, Hatteras will benefit from higher adjusted rates on its portfolio, while a chunk of its financing is at a low fixed rate. In addition, if rates do rise the pre-payment of mortgages should slow down, which would improve the value of the company's securities as well. Long story short, today Hatteras is running a thin margin, but in the long-run the company is investing for higher rates. If you look at the type of dividend investors can expect from Hatteras, it compares well to their competition.

Let's face it, the reason investors buy mREITs is the yield. However, too many times I've heard investors and analysts quote trailing yield, which makes no sense with this type of company. Since their dividends are a function of earnings, unless they earn the same in the future as they did in the past, their yield will change. Looking at the four companies I mentioned earlier, I calculated their future yield based on next year's earnings projections. If Hatteras meets its projected earnings target of $3.06, and pays 90% of this in dividends, investors should receive a future yield of about 10.4%.

By comparison, Invesco would pay an 11.04% yield, Chimera would pay over 14%, and Annaly would pay about 9.13%. Now some might say that Invesco and Chimera sound better than Hatteras, and I would agree, but only to a point. You have to understand that Invesco buys securites that are both agency and non-agency, and the company has a longer-term duration to its portfolio. If rates begin to rise, Invesco will suffer more than Hatteras because they are tied to longer-term loans. Where Chimera is concerned, investors have to be comfortable with their non-agency type of investment. These differences leave Hatteras as an attractive option in the agency securities investment business.

If you are looking for a company that can give you excellent current income, and should pay an over 10% yield next year too, look no further than Hatteras. The company is matching its borrowing and lending much like banks try to do, and if rates rise over the next two to three years, Hatteras should do well. The fact that the company specializes in adjustable rate securities gives them less competition for their investments compared to fixed rate purchasers like Annaly. You have to accept that the dividend will change with earnings, but that's not always bad news. Though the dividend was cut recently, once mortgage rates begin to rise, Hatteras will be there with a higher yield. Long-term investors should be happy to collect an over 10% yield, while waiting for even better results down the line.

MHenage owns shares of Chimera Investment, Invesco Mortgage Capital, Hatteras Financial, and Annaly Capital Management. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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