Closed-End Fund Transition Unlocks 28% Capital For Future CLO Investments

Key Takeaways

• Transitioning to a closed-end fund aims to enhance operational efficiencies and capital allocation, potentially boosting net margins.
  
• Shifting focus to CLOs increases net interest income and earnings, driving growth through market inefficiencies and improved revenue.
  
• High interest rate volatility and market dynamics could negatively impact Ellington Credit's earnings, margins, and profitability, with liquidity and asset management risks adding further challenges.

Catalysts

A real estate investment trust, acquires, invests in, and manages residential mortgage-and real estate-related assets.

• The conversion to a closed-end fund, effective April 1, is expected to provide operational efficiencies, lower debt-to-equity ratios, and better access to capital markets, potentially enhancing capital allocation and tax efficiencies, ultimately impacting net margins positively.
  
• The strategic shift in portfolio allocation towards CLOs from Agency RMBS is expected to drive future growth, with an increased allocation to CLO equity projected to enhance net interest income and earnings.
  
• There is a significant increase in the CLO portfolio, with a focus on exploiting pricing inefficiencies and volatility across U.S. and European markets, which is anticipated to lead to higher revenue and improved adjusted distributable earnings.
  
• The sale of the Agency RMBS pools post-conversion is expected to free up approximately 28% of non-CLO capital, providing liquidity that could be opportunistically deployed to capitalize on market inefficiencies, supporting revenue and earnings growth in the upcoming quarters.
  
• Strong performance and strategic positioning in the CLO market, including capturing opportunities from credit spread contractions and enhancements in net interest margins, are expected to drive robust returns and positively impact earnings.

Ellington Credit Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Ellington Credit's revenue will grow by 3.3% annually over the next 3 years.
• Analysts assume that profit margins will increase from 16.0% today to 92.6% in 3 years time.
• Analysts expect earnings to reach $42.2 million (and earnings per share of $1.42) by about May 2028, up from $6.6 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 8.9x on those 2028 earnings, down from 32.0x today. This future PE is lower than the current PE for the US Capital Markets industry at 24.5x.
• Analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 11.41%, as per the Simply Wall St company report.

Ellington Credit Future Earnings Per Share Growth

Risks

• Continued high levels of interest rate volatility could negatively impact Ellington Credit's earnings, particularly affecting their revenue from the Agency MBS portfolio and potentially leading to net losses similar to those experienced in the fourth quarter.
  
• The transition to a closed-end fund and subsequent divestment of agency pools may carry risks related to liquidity and asset management, which could impact net margins and the book value if not managed optimally.
  
• Market volatility and credit spread dynamics in the CLO market could affect the pricing of CLO equity investments, leading to potential fluctuations in net interest margins and earnings.
  
• Potential longer-term fundamental stresses on corporate borrowers could pose risks to the performance of CLO portfolios, affecting overall revenue and profitability if loan defaults increase.
  
• The 28% of capital tied up in the agency portfolio until April 1 limits their ability to immediately capitalize on current market opportunities, potentially affecting net interest margins and delaying improved earnings performance.

Valuation

• The analysts have a consensus price target of $5.875 for Ellington Credit based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $6.5, and the most bearish reporting a price target of just $5.25.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be $45.5 million, earnings will come to $42.2 million, and it would be trading on a PE ratio of 8.9x, assuming you use a discount rate of 11.4%.
• Given the current share price of $5.61, the analyst price target of $5.88 is 4.5% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.