In a note to its investors on November 16, Wells Fargo upgraded the stock of Annaly Capital Management (NLY) from market perform to outperform as part of a broader call on the mortgage REITs sector of the US. Annaly Capital Management is the largest US residential mortgage REIT. It was hit hard by the third round of quantitative easing (QE3). However, I believe that the stock is oversold at its current book value multiple. The company's recent change in strategy is a good step towards steering the company through QE3. The stock presents an excellent opportunity of price appreciation and an unmatched dividend yield of 13.5%. Therefore, I recommend our investors to buy Annaly Capital and benefit from a combination of capital appreciation and an elevated dividend yield.
Implications of QE3
The US mortgage REITs sector was hit hard by QE3 and as a consequence of that, share prices of most of the residential mortgage REITs that invested exclusively in fixed rate agency mortgage backed securities plunged. The stock of Annaly Capital lost over 10% of its value, while the stock of American Capital Agency (AGNC) lost over 9% of its value since the announcement of the launch of QE3 on September 13. The chart below clearly demonstrates the decline in the share price of Agency mortgage REITs (Annaly Capital, American Capital Agency, Capstead Mortgage (CMO) and Armour Residential (ARR)) compared to REITs that invest largely in non-agency residential mortgage backed securities (Newcastle Investment Corp (NCT) and PennyMac Mortgage Investment Trust (PMT)).
Through QE3, the Fed intends to buy mortgage backed securities worth $40 billion a month, which has resulted in an appreciation in the prices of these securities and the resultant decline in their yields. The Mortgage Bankers Association (MBA) recently reported all time low mortgage rates. The 30-year mortgage rate dipped to 3.34%, said Freddie Mac. This is the lowest since 1971, while the 15-year mortgage rate plunged to 2.65%. Where it is a positive for the US housing sector, as homeowners are being encouraged to borrow more, a prolonged QE3 could be devastating for the US residential mortgage REIT sector.
Annaly Capital Change in Strategy
The proposed acquisition of CreXus Investment (CXS), which largely invests in commercial real estate, including commercial mortgage loans and commercial mortgage backed securities, is the right step given the current economic environment post QE3. Annaly Capital is expected to purchase each share of CreXus for $12.5 in cash, representing a 5% premium to third quarter book value. Annaly already owns 12.4% of CreXus, which removes the risk of integration for this proposed acquisition.
Since the company's charter gives Annaly the leverage of having up to 25% of assets in non-agency securities, the company has decided to use this leverage and allocate 25% of its equity to assets other than agency residential MBS.
The above steps would move Annaly Capital away from its exclusive agency mortgage REIT status to a more diversified strategy.
Rating Upgrades and Downgrades
Considering the change in the company's strategy, analysts at Wells Fargo upgraded Annaly Capital to outperform from its previous rating of market perform. Annaly Capital has rarely traded at such low book value multiples. Wells Fargo believes the stock in particular and the sector in general is oversold, which creates an excellent buying opportunity for investors.
With a rating of underperform, FBR Capital cut its target price for Annaly to $13.5 from its previous target of $16.0. Similarly, analysts at Nomura also cut their target price for the stock to $15.0, while Jefferies Group reiterated their hold rating in a note to their investors.
The stock offers an unmatched dividend yield of 13.5% well backed by over 39% operating cash flow yield (TTM). During the most recent quarter, the company paid $545 million in dividends to its shareholders, while it generated $3.6 billion in operating cash flow the same quarter. This reflects the fact that the company has sufficient cash to sustain the shareholder distributions in the coming future.
Currently Annaly is trading at a price to book value multiple of 0.89 times, against 0.95 times for American Capital Agency. Applying a book value multiple of 0.95 times and the third quarter book value, we arrive at a target price of $15.7. Currently, the stock is trading at $14.8, which gives investors an upside of 6%.
Based on the change in the company's strategy to move away from Agency-only mortgage REIT, I recommend investors to buy Annaly Capital. Wells Fargo supports our stance on the stock. We also favor mortgage REITs that invest largely in non-agency securities PennyMac Mortgage Investment. I won't be surprised if American Capital Agency and other pure play REITs follow Annaly in such a challenging environment.