Increased Investment In Agency RMBS And Treasury Futures Will Stabilize Future Earnings

Key Takeaways

• Capital structure improvement and diversified interest rate hedges aim to enhance margins and stabilize earnings, leveraging U.S. Treasury futures to mitigate volatility.
  
• Strategic allocation to Agency RMBS and CMBS targets revenue growth and stability, supported by favorable market conditions and attractive risk-adjusted returns.
  
• High interest rate volatility and macroeconomic uncertainty may dampen demand for agency mortgages, challenging revenue growth and earnings potential.

Catalysts

Operates as a real estate investment trust (REIT) that invests, finances, and manages mortgage-backed securities and other mortgage-related assets in the United States.

• Invesco Mortgage Capital has notably improved its capital structure and reduced its cost of capital by redeeming its Series B preferred stock in favor of lower cost repurchase agreements. This initiative is expected to positively impact net margins by decreasing the expense related to capital costs.
  
• The company has diversified the composition of its interest rate hedges, increasing its allocation to U.S. Treasury futures. This strategy is expected to reduce exposure to swap spread volatility and contribute to more stable earnings over time.
  
• The focus on higher coupon Agency RMBS and increased allocation to Agency CMBS is designed to leverage declining interest rate volatility and capitalize on attractive valuations. This strategic positioning is anticipated to positively impact revenue growth by optimizing portfolio returns.
  
• Increased agency commercial mortgage-backed securities (Agency CMBS) investment, as the sector provides prepayment protection and attractive risk-adjusted returns. This is expected to enhance future earnings through improved portfolio diversification and stability.
  
• U.S. banks’ expected continued demand for Agency RMBS, enabled by deregulation and a steeper yield curve, creates a favorable environment for Invesco Mortgage Capital's investment portfolio, potentially driving revenue growth and economic returns as demand for RMBS strengthens.

Invesco Mortgage Capital Future Earnings and Revenue Growth

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Invesco Mortgage Capital's revenue will grow by 48.4% annually over the next 3 years.
• Analysts assume that profit margins will increase from 60.6% today to 67.7% in 3 years time.
• Analysts expect earnings to reach $178.2 million (and earnings per share of $1.61) by about June 2029, up from $48.8 million today.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 7.3x on those 2029 earnings, down from 15.1x today. This future PE is lower than the current PE for the US Mortgage REITs industry at 11.4x.
• 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 10.24%, as per the Simply Wall St company report.

Risks

• The decrease in book value per common share of 4.8% and a negative economic return of 0.5% for the quarter indicate performance challenges, potentially impacting future earnings and share price.
  
• Increased debt-to-equity ratio due to redemption of Series B preferred stock could heighten financial risk and impact net margins if borrowing costs rise unexpectedly.
  
• High interest rate volatility and macroeconomic uncertainty, including changes in fiscal and monetary policy, could diminish demand for agency mortgages, impacting revenue and earnings.
  
• The company's cautious outlook on agency mortgages due to fiscal uncertainties may imply constrained revenue growth, limiting future earnings potential.
  
• Ongoing quantitative tightening and reduction of the Federal Reserve's balance sheet could continue to impact agency RMBS demand, affecting revenue and profit margins.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $8.5 for Invesco Mortgage Capital 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 $9.5, and the most bearish reporting a price target of just $7.75.
• In order for you to agree with the analysts, you'd need to believe that by 2029, revenues will be $263.4 million, earnings will come to $178.2 million, and it would be trading on a PE ratio of 7.3x, assuming you use a discount rate of 10.2%.
• Given the current share price of $7.91, the analyst price target of $8.5 is 6.9% 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.