CLO Strategy Shift Promises Transformative Growth And Earnings Boost

Key Takeaways

• Strategic transformation into a CLO-focused fund aims to boost risk-adjusted returns, while active management seeks to improve net margins.
  
• Expansion in CLO equity investments and strategic moves like reducing leverage and diversifying into European markets aim to enhance earnings and diversification.
  
• Transition to CLO-focus raises risks from market volatility, prepayment rates, and credit spread changes, potentially affecting earnings, net asset values, and tax efficiency.

Catalysts

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

• The strategic transformation into a CLO-focused closed-end fund is expected to generate superior risk-adjusted returns for shareholders, enhancing future revenue and net income.
  
• Active management of the CLO portfolio, including opportunistic sales and acquisitions, aims to capitalize on market dislocations and spreads tightening, thereby improving net margins from these investments.
  
• Expansion of the CLO equity investments, particularly those benefiting from tightening new issue debt spreads, is likely to increase distributable earnings over the coming quarters.
  
• The decrease in leverage ratio to 3x, as management focuses on lower leverage and higher shareholders' equity, suggests a strategy aimed at improving the company's risk profile and potentially enhancing earnings quality.
  
• The strategic allocation to European CLO investments for diversification and capturing compelling relative value opportunities signifies a forward-looking approach to tap into international markets, potentially impacting both revenue growth and earnings.

Assumptions

• Analysts are assuming Ellington Credit's revenue will grow by 38.6% annually over the next 3 years.
• Analysts assume that profit margins will increase from 22.6% today to 77.3% in 3 years time.
• Analysts expect earnings to reach $37.9 million (and earnings per share of $1.46) by about October 2027, up from $4.2 million today.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 6.0x on those 2027 earnings, down from 40.8x today. This future PE is lower than the current PE for the US Capital Markets industry at 21.4x.
• Analysts expect the number of shares outstanding to grow by 0.78% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 7.8%, as per the Simply Wall St company report.

Risks

• The conversion to a CLO-focused closed-end fund involves reliance on high corporate loan prepayment rates which, if they diminish, could lead to decreased earnings due to lower income from rapid repayments. This could impact net income and distributable earnings.
  
• As noted during the call, market volatility and widening credit spreads can lead to mark-to-market losses on CLO equity tranches, which impacts net asset values and could decrease shareholders' equity and overall financial stability.
  
• The ongoing rotation out of Agency MBS into CLOs might not yield the anticipated results if the CLO market experiences unexpected downturns or if the cost of liquidating agency investments becomes higher than expected, thereby reducing the net interest margin and affecting overall profitability.
  
• Dependence on certain CLO mezzanine debt investments for income could risk earnings if these investments are called at par or if their market value decreases due to changes in the credit market, especially considering the recent tightening of credit spreads which may not continue, impacting future earnings and portfolio value.
  
• Tax implications arising from the revocation of the REIT election and the shift to operating as a taxable C-Corp could create a financial drag if the company is unable to efficiently utilize its net operating loss carryforwards, potentially affecting net income by increasing the tax burden.

Valuation

• The analysts have a consensus price target of $7.25 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 $8.0, and the most bearish reporting a price target of just $6.5.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $49.0 million, earnings will come to $37.9 million, and it would be trading on a PE ratio of 6.0x, assuming you use a discount rate of 7.8%.
• Given the current share price of $6.71, the analyst's price target of $7.25 is 7.4% 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.