PMT, AGNC, TWO, and CSWC Q3 2023 Updates by Scott Kennedy

Introduction section by Colorado Wealth Management Fund.

Article section by Scott Kennedy.

There are four articles contained in this post. They are earnings updates for:

1. PennyMac Mortgage Trust (PMT)

2. AGNC Investment (AGNC)

3. Two Harbors (TWO)

4. Capital Southwest (CSWC)

They will be presented in that order.

• The article for PMT will be included for free.

• The articles for AGNC, TWO, and CSWC will be exclusive to full members.

Each update is designed to serve as a stand-alone article, but I’m packing them all into one e-mail for simplicity. I’ve modified the layout to place repeating parts at the start or end of the e-mail.

Bringing More of Scott’s Work to Our Website

The REIT Forum is a service produced by Michael Vanloon (better known as Colorado Wealth Management Fund) and Scott Kennedy. After intense consideration, I decided to launch our service through Substack. Since then, we’ve seen great success. Substack enables us to give readers real-time alerts with entire articles delivered directly to their inboxes.

You’re probably used to seeing the “from” field saying: “ColoradoWealthManagementFund from The REIT Forum”.

In some of our future e-mails, it may say:

“Scott Kennedy from The REIT Forum”.

That will simply mean we’ve updated the backend of the website for Scott Kennedy to directly post his articles.

I want to make browsing our work as simple as possible for readers. This will be another step in that direction.

For the moment, I’ll be posting Scott’s work. The following articles are a direct copy and paste from Scott. While we get the back end set up, there is a delay in getting the articles posted. Rest assured that it should be solved soon.

Finding Our Positions

I posted a subscriber-exclusive article with links to our Google Sheets. You can always access our positions there. Scott’s positions are updated each week. CWMF’s positions are usually updated on the same day as the trade.

Disclosures

Related to the stocks in this article:

CWMF is long PMT-B (PMT.PB), PMT-C (PMT.PC), AGNCP (AGNCP), and CSWC.

Scott Kennedy is long CSWC.

The rest of this post is from Scott Kennedy.

Introduction:

Hi subscribers. For new members, my name is Scott Kennedy and currently I fully cover 20 mortgage real estate investment trust (mREIT) and 15 business development company (“BDC”) common stocks within this Investing Group regarding research/data, subscriber questions, weekly projected book values/net asset values (BV/NAV), and common stock recommendation ranges. Colorado (“CO”) Wealth Management handles the mREIT preferred stocks and he and his team handles all other applicable REIT sectors outside the mREIT sector. CO also provides some mREIT common stock and BDC articles from time-to-time which are more of an “overview/introduction” discussion; typically based either on my or our combined research/data. This also includes some macroeconomic trends and data. My name is always attached to all Investing Group articles I personally wrote so there is no confusion for subscribers.

This REIT Forum article is part of a series of articles over a span of 6-7 weeks which will analyze my previously projected BV/NAV and core earnings (or core earnings equivalent)/net investment income (“NII”) figures and compare these metrics to each mREIT’s and BDC’s actual reported results, respectively. For readers who are familiar with my public mREIT and/or BDC articles, these types of articles are beneficial to readers who desire to pursue a more active investing strategy and/or want more “real time” thoughts/analysis.

I hope my services/contributions ultimately help enhance a subscriber’s total investment returns or minimize their total investment losses within the mREIT and BDC sectors. At the very least, I hope subscribers will gain more insight into the mREIT and BDC sectors by reading my/our exclusive REIT Forum articles.

Article #1: Scott Kennedy’s mREIT Earnings Series: Assessing PennyMac Mortgage’s Performance For Q3 2023

Summary

• This article also discusses how PMT’s quarterly change in BV and net interest spreads/margins “matched up” to expectations. Earnings remain a key driver to stock performance.

• PMT’s BV was a modest-notable outperformance while its net interest spreads/margins was a minor outperformance.

• No change in PMT’s percentage recommendation ranges or risk rating.  PMT is currently deemed undervalued (BUY).  PMT's adjusted diluted EPS guidance was raised $0.05 per common share (a positive catalyst/trend).

• Overall, PMT reported a good-very good quarter.  PMT's quarterly BV outperformance mainly factored around aggressive MSR valuation assumptions/inputs (something to be mindful of regarding future quarters).

PMT’s BV and Net Interest Margin Q3 2023 Performance (Projected Versus Actual Results):

On 10/26/2023, PennyMac Mortgage Investment Trust (PMT) reported the company’s earnings results for the third quarter of 2023. Table 1 below provides PMT’s BV and earnings summary.

Table 1 – PMT Q3 2023 BV and Earnings Summary

Source: Taken Directly from the REIT Forum’s © Analytical Spreadsheets/Data

PMT reported a BV as of 9/30/2023 of $16.01 per common share (1.3% increase) versus my prior projection of $15.25 per common share (3.5% decrease). I consider this a modest (at or greater than a 2.5% but less than a 5.0%) – notable outperformance and was OUTSIDE my $14.70 - $15.85 per common share range.

Even when considering all the moving parts within PMT’s business model (numerous sub-portfolios), along with continued notable sector volatility regarding asset pricing and all the types of derivative instruments management utilizes at any given point in time, I was a bit disappointed with my PMT quarterly BV projection. This quarter’s BV variance was in direct contradiction to basically matching PMT’s BV last quarter. Simply put, the vast majority of PMT’s BV outperformance was within the company’s mortgage servicing rights (“MSR”) sub-portfolio. Over the past several quarters, my MSR projected valuation gains (losses) have closely aligned to what PMT has reported. However, there was some “de-coupling” of expectations during the third quarter of 2023 which I will discuss in a bit. Let us first discuss/reconcile how all of PMT’s segments performed when compared to my expectations.

First, I correctly anticipated PMT would experience relatively flat/unchanged correspondent loan acquisitions/volume within the company’s origination/production platform during the third quarter of 2023 when compared to the second quarter of 2023. PMT had conventional correspondent loan acquisitions of $21.5 billion during the third quarter of 2023. When calculated, this was a quarterly increase in loan acquisitions of $0.4 billion or 2%. In comparison, I projected a total correspondent loan acquisition mean increase of 2.5%. As such, basically an exact match. In addition, after a “trough/low” during the fourth quarter of 2021, PMT has experienced a slow, gradual net rebound in the company’ gain-on-sale (“GOS”) margin during the second quarter of 2022 – third quarter of 2023. This has been a very gradual rebound. This factor/trend is not going to notably change anytime soon. PMT recorded a net valuation gain on loans acquired for sale within the company’s correspondent loans sub-portfolio of $14 million during the third quarter of 2023. In comparison, I projected a net valuation gain of $5 million on a slightly lower GOS margin. When calculated, this $9 million variance directly led to a BV outperformance of $0.10 per common share when compared to my expectations.

Second, PMT experienced a similar valuation fluctuation within the company’s credit-risk-transfer (“CRT”) sub-portfolio when compared to my expectations. CRT investments, as a whole, continued to experience a minor amount of spread tightening during the third quarter of 2023. At times, this can be a “tricky” sub-portfolio to value. Since these specific CRT investments are Level 3 assets per Accounting Standards Codification (“ASC”) 820, there is a good deal of “managerial judgement/assumptions” that go into this valuation. As such, even without a notable change in underlying tranches/vintages or overall structure/composition, valuation fluctuations can “meander” from my modeled projections time-to-time but that did not occur this quarter. PMT recorded a net valuation gain of $30 million during the third quarter of 2023 regarding the company’s CRT sub-portfolio. In comparison, I projected a net valuation gain of $25 million. Credit risk within PMT’s various CRT vehicles has remained very subdued which remains a positive catalyst/trend (but this was already previously anticipated). When calculated, this $5 million variance directly led to a BV outperformance of $0.06 per common share when compared to my expectations.

Third, while I correctly anticipated PMT would record a fairly large net valuation gain within the company’s MSR sub-portfolio, the level was enhancement management actually recorded, in my professional opinion, was very aggressive. As first explained 4 quarters ago, MSR multiples and valuations are getting closer and closer to a “ceiling” per se (attempting to use a reference that more subscribers can relate to). It is not an absolute ceiling but there is more and more resistance nonetheless. Fairly similar to the concept of convexity risk in bonds. As constant/conditional prepayment rates (“CPR”) continue to lower as mortgage interest rates/U.S. Treasury yields have risen during 2022-2023, it becomes harder and harder for CPRs/MSR multiples to continue to experience the same level of quarterly decreases/enhancements the lower the percentage/the higher the multiple was at the start of any given quarter. However, with overall intermediate- to long-term rates/yields taking a leg higher during the third quarter of 2023, MSR valuations have moved above their recent plateau. That said, PMT is now very aggressive with forward long-term expectations. Long story short, unlike the prior 5 quarters, PMT’s MSR sub-portfolio modestly - notably outperformed my expectation during the third quarter of 2023.

To put this into better perspective, RITM’s MSR sub-portfolio experienced a quarterly increase in valuation multiples from 5.0x during the second quarter of 2023 to 5.1x during the third quarter of 2023. In comparison, PMT’s MSR sub-portfolio experienced a quarterly increase in valuation multiples from 5.9x during the second quarter of 2023 to 6.3x during the third quarter of 2023. Now, of course, RITM’s and PMT’s underlying MSR sub-portfolio is different (topic for a different day). However, I would just point out the quarterly change in valuation multiples between the 2 sub-sector peers. RITM’s MSR valuation multiple increased 0.1x during the third quarter of 2023 while PMT experienced an increase of 0.4x. Simply put, a noticeably more aggressive multiple increase. In comparison, I projected a PMT MSR multiple increase of 0.2x. PMT’s MSR sub-portfolio reported a $161 million net valuation gain during the third quarter of 2023. When broken out, this included MSR amortization of ($102) million and “pure” valuation changes of $263 million (based on longer-term prepayment and default expectations). In comparison, I projected MSR amortization of ($105) million and “pure” valuation changes of $205 million. When calculated, this $61 million net variance directly led to a BV outperformance of $0.70 per common share when compared to my expectations.

Next, PMT’s mortgage-backed securities (“MBS”) sub-portfolio very slightly outperformed my expectations. This was mainly due to PMT basically maintaining the company’s fixed-rate agency MBS sub-portfolio during the third quarter of 2023. I expected a slightly larger increase which would have led to a slightly more severe net valuation loss. PMT recorded a net valuation loss of ($144) million during the third quarter of 2023. In comparison, I projected a net valuation loss of ($150) million. When calculated, this $6 million variance directly led to a BV outperformance of $0.07 per common share when compared to my expectations.

Next, let us discuss the company’s hedging/derivative instruments sub-portfolio. PMT reported a derivatives net valuation loss of ($51) million during the third quarter of 2023. In comparison, I projected PMT would report a derivatives net valuation loss of ($50) million. As pointed out in the past, management utilizes 10 - 15 different types of hedges during any given quarter (very complex versus most peers). In addition, unlike most sector peers, PMT constantly switches between net long (short) positions during the quarter in some instruments as management sees fit regarding interest rate risk strategies. In the past, during a couple fairly recent quarters, PMT’s management team has “dropped the ball” per se in trying to correctly identify how interest rates would move during a particular quarter. This quarter was not one of those quarters (as anticipated performance). When calculated, for the 2^nd straight quarter, this ($1) million variance directly led to a BV underperformance of ($0.01) per common share when compared to my expectations.

Finally, let us review the company’s income tax (provision)/benefit account. This can be one of those “quirky” accounts from quarter-to-quarter as well. Due to PMT recording a larger MSR net valuation gain via the company’s taxable REIT subsidiary (“TRS”), management recorded an income tax provision of ($57) million during the third quarter of 2023. In comparison, on an assumed less enhanced MSR net valuation gain, I projected an income tax provision of ($40) million. When calculated, this ($17) million variance directly led to a BV underperformance of ($0.18) per common share when compared to my expectations.

When all the variances noted above are combined, along with a $0.02 per common share outperformance on PMT’s net spread metrics and no BV accretion from no common or preferred share repurchases, this fully reconciles to the company’s quarterly BV outperformance of $0.76 per common share when compared to my expectations.

Moving on, unfortunately, PMT is one of the rare mREIT peers that does not provide an “official” core earnings/earnings available for distribution (“EAD”) metric. As such, I cannot provide commentary on that specific metric. When strictly reviewing net spreads (which excludes unrealized and realized valuation gains/losses), PMT reported a relatively unchanged net spread during the third quarter of 2023 when compared to the prior quarter. Simply put, a minor decrease in interest income was basically matched by a minor decrease in interest expense. As noted above, PMT’s net spread metric outperformed my expectations by $0.02 per common share during the third quarter of 2023. It should also be noted there’s a bit of “static” in strictly looking at this generalized metric as lower correspondent production/volume typically results in lower gains (or even losses); yet lower origination/production volume also leads to lower expenses (and not a 100% match in income/fees).

PMT now forecasts, prior to any quarterly valuation fluctuations, adjusted diluted earnings of $0.35 per common share over the foreseeable future. This is a $0.05 per common share increase when compared to the second quarter of 2023 (but still a net decrease from the company’s $0.40 per common share estimate during the first quarter of 2023). When compared to the prior quarter, this is a positive catalyst/trend and likely one of the reasons for the market’s strong/positive reaction in PMT’s stock price today. As noted 2 quarters ago, I remain mindful of the potential for another PMT dividend reduction over the next several quarters. That said, this warning is a bit less alarming due to PMT’s higher adjusted diluted earnings guidance disclosed this quarter. My/Our previously-disclosed PMT dividend range of $0.35 - $0.40 per common share remains unchanged for the fourth quarter of 2023.

So, all-in-all, a modest - notable outperformance on PMT’s BV (variance of 4.8%) and a minor outperformance on the company’s net spread income (variance of $0.02 per common share). So, a good – very good quarter for PMT but a large part of the company’s outperformance directly stemmed from, in my professional opinion, a very aggressive valuation within its MSR sub-portfolio (just something to keep in mind moving into the fourth quarter of 2023; less valuation gains/steeper valuation losses in future quarters).

When taking PMT’s recent and projected performance into consideration, along with macroeconomic trends/events (mainly Fed monetary policy, the general projected movement of rates/yields, and projected economic performance over the foreseeable future), no change to my/our PMT percentage recommendation ranges (relative to CURRENT BV) or risk rating (remains at a 3.5). That said, due to PMT’s modest - notable 9/30/2023 BV outperformance, I/we performed a CURRENT BV “true-up” adjustment which raised the company’s per share recommendation ranges by approximately $0.75 per share. This true-up CURRENT BV adjustment is already reflected in the Google subscriber spreadsheets.

With a closing price as of 10/27/2023 of $12.28 per share, PMT is deemed to be UNDERVALUED/a BUY recommendation (price target of $15.60 per share). As such, even with the 14%+ move higher today, PMT still has some value. That said, not nearly as much value when compared to PMT’s stock price prior to earnings. I would point out last week PMT, prior to earnings, moved into my/our NOTABLY UNDERVALUED/STRONG BUY recommendation range.

Conclusions Drawn + BUY, SELL, or HOLD Recommendation:

Readers have continued to request that I provide these types of “earnings assessment” articles showing how my previously disclosed quarterly projections “stacked-up” to each covered mREIT’s/BDC’s results. I believe the analysis above accomplishes this request for the REIT Forum subscribers.

In summary, here is how PMT performed when compared to my expectations regarding the third quarter of 2023 (includes any risk rating and BUY, SELL, or HOLD recommendation range changes; as well as current recommendation):

PMT

BV: Modest-Notable Outperformance (OUTSIDE Range)

Core Earnings: N/A

Net Interest Margin/Spread Income: Minor Outperformance (Within Range)

Percentage Recommendation Range (Relative to CURRENT BV): No Change (Reasoning Provided Above)

Risk Rating: No Change

PMT Notecard (As of 10/27/2023):

(Source: Taken Directly from the REIT Forum’s © Subscriber-Accessible Spreadsheets. Earnings Projection is Taken Directly from Either the Prior Quarter’s Actual Reported Figure or the Institutional Analysts’ Consensus Average and Annualized. At the End of Each Current Quarter, I Provide My Own Finalized Core Earnings/Core Earnings Equivalent or NII/Adjusted NII Metric Which Will Differ from the Estimate Provided Above.)

Important Note: As always, please check the Google shared spreadsheets when it comes to intra-week recommendations as stock prices fluctuate.

See Additional Factors Considered for catalysts/factors at the end of the article.

See Understanding My Valuation Methodology Regarding mREIT Common and BDC Stocks at the end of the article for details on methodology.

The next 3 articles (PMT, TWO, and CSWC) are restricted to paid members of our service.