It's Not Too Late for Great Mortgage Stock Plays: FBR

NEW YORK ( TheStreet) -- Heading into second-quarter earnings season for financial companies, a major theme is the slowdown in mortgage lending, but FBR analyst Paul Miller sees two golden opportunities for investors in the mortgage space.

Miller late on Tuesday initiated his firm's coverage of PennyMac Financial Services ( PFSI) and PennyMac Mortgage Investment Trust ( PMT) with "outperform" ratings.

PennyMac Financial Services is a mortgage lender that also focuses on managing mortgage-related investments. The company was founded in 2008 and went public on May 9, at an opening share price of $18.25. PennyMac's stock closed at $20.72 Wednesday. Miller's price target for the shares is $25, implying 21% upside.

PFSI trades for 6.8 times the consensus 2014 earnings estimate of $3.02 a share, among analysts polled by Thomson Reuters. The consensus 2013 EPS estimate is $2.12. Miller estimates the company will earn $1.85 a share this year, with earnings rising to $2.85 a share in 2014.

PennyMac Mortgage Investment Trust is a REIT that invests in mortgage loans, including those originated by PFSI, along with distressed loans and mortgage servicing rights. PMT is managed by PFSI, and its loans are serviced by PFSI. PennyMac Mortgage Investment Trust went public in July 2009. PMT closed at $21.27 Wednesday, down 14% this year, following a 70% return during 2012.

PMT trades for 6.8 times the consensus 2014 EPS estimate of $3.14. The consensus 2013 EPS estimate is $3.11. Miller estimates the REIT will earn $2.90 a share this year, with earnings growing slightly to $3.00 a share in 2014.

Based on a quarterly payout of 47 cents, PMT's shares have a dividend yield of 10.72%.

It's no secret that rising long-term rates can hammer dividend stocks, and the market yield on 10-year Treasury bonds rose to 2.70% Wednesday from 1.70% at the end of April.

Two Industry Threats

JPMorgan Chase ( JPM) and Wells Fargo ( WFC) will kick off earnings season for the nation's largest banks on Friday. Both companies are major mortgage lenders, with Wells Fargo currently holding the largest mortgage lending market share.

The consensus among analysts is for Wells Fargo to report second-quarter earnings of 93 cents a share, rising just a penny from the previous quarter. Analysts expect JPMorgan to report second-quarter EPS of $1.44, declining from $1.59 in the first quarter.

Mortgage industry volumes are expected to continue their sharp decline. The Mortgage Bankers Association estimates that total originations of one-to-four-family mortgage loans in the U.S. will decline to $1.572 trillion this year from $1.750 billion during 2012. The MBA expects a much more dramatic decline in loan volume during 2014, with total originations of $1.091 billion.

Rising long-term rates may play a part in the decline in mortgage loan volume, and higher rates have already lowered gain-on-sale margins for mortgage lenders. Then again, rising rates bode well for mortgage servicing rights (MSRs) held by PMT. The carrying value of MSRs increase as rates rise, since loan refinancing becomes less likely.

Miller in a note to on Wednesday wrote that he expected revenues for PFSI and PMT to continue to increase, since "both will benefit as their originations rise, MSR assets grow, and economic recovery improves distressed asset valuation." Even with total industry volume expected to continue to decline, the analyst believes "the entities' origination market share has room to grow as the companies expand their correspondent relationship base and build out a retail origination platform."

"Rising rates are generally considered the bane of a mortgage originator's existence; however, when rising rates are also associated with a broad-based housing recovery and mild economic improvements, servicing assets such as those PFSI has been generating become more valuable," Miller wrote.

He added that "PMT is more levered to the performance of its problem loan portfolio, while PFSI is more exposed to mortgage market strength. Both sides of the coin are attractive in the current macroeconomic environment, as we estimate that originations will remain elevated for the foreseeable future and expect that consumer credit recovery is likely to continue for some time, supporting high returns at each company."

It's clear that after last year's stellar return, with the recent sharp increase in long-term rates, and the expectation that the Federal Reserve will curtail its bond purchases by the end of the year, there's plenty of market pressure on a high dividend payer like PennyMac Mortgage Investment Trust. But the REIT's earnings should see a healthy boost from the housing recovery, which will push it the value of its distressed loans. The REIT will also benefit from the MSR valuation boost from higher rates.

"With normalized pretax profitability of 15 bps to 30 bps for PMT's origination business and the relatively sheltered nature of PFSI's origination profitability (given a fee arrangement with PMT), we are optimistic that market share growth will be enough to overcome any potential volume fallout across the industry, as well as compressing margins at both entities," Miller wrote.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.