It has been a tough quarter for Annaly Capital Management (NLY), as well as the rest of the mortgage REITs that we have been following, as evidenced by this stock chart:
(click to enlarge)
But, you have to be intrigued by this press release, which outlines the company's forward plan. To summarize, the company has announced a $1.5B common share buyback, an issuance of additional notes at 6.3% in the same amount. Also, the company will convert up to 25% of its shareholders' equity to non-agency mortgages.
So, the project of the day is to try to figure out the potential effects of all of this on the share price.
First, a little background information from the most recent 10Q:
| Balance Sheet MRQ as of 9-30-2012 | Dollars |
| Total Assets | $141,000,000,000 |
| Cash | $2,260,000,000 |
| Portfolio | $129,000,000,000 |
| Repurchase Agreements | $101,000,000,000 |
| Stockholders' Equity | $17,000,000,000 |
| Repurchase Agreement/Equity Ratio | 5.94 |
| Portfolio/Equity Ratio | 7.59 |
| Assets/Equity Ratio | 8.29 |
The most interesting number in this table is the $2.3B in cash that NLY raised during the last quarter. As we pointed out the other day, this company consistently kept about $900M cash on hand throughout most of the past year, so there was some foreshadowing of some of these events for those who could see it.
Here is the effect of the refinancing activities:
| Effect of Refinancing | |
| Current Common Share Price | $14.75 |
| Share Buyback | $ 1,500,000,000 |
| Current Shares Outstanding | 1,956,000,000 |
| Shares Available for Purchase | 101,694,915 |
| New Shares Outstanding | $ 1,854,305,085 |
| Dividend/Share (Current)(Quarterly) | $ 0.50 |
| Dividend Cost/Year Savings | $ 203,389,831 |
| Notes Issued | $ 1,500,000,000 |
| Interest Rate | 6.30% |
| Est Interest Rate Expense/Year | $ 94,500,000 |
| Net Effect of Refinancing | $ 108,889,831 |
| Net Effect of Refinancing per Share Common | $ 0.06 |
| Dividend Pass Through Rate | 0.8 |
| Potential Incremental Dividend | $ 0.05 |
| Potential Stock Price Effect @ 13.6% yield | $ 0.35 |
The intent of the refinancing is obviously to replace the common equity, which comes at a price of 13.6% dividend yield as of the moment, with lower cost debt. A year ago, a lot of these mortgage REITs were issuing additional shares in order to increase their portfolio. Sometime during the spring, depending on the company, many of these companies started to issue preferred stock at 7-8%. This allowed them to raise money at a lower cost. This move by NLY is just a logical extension of that strategy.
In this case, swapping the common equity for debt will reduce NLY's dividend expense by $200M/year, while increasing its interest expense by $94.5M/year, a net benefit of $105M to the bottom line, which computes to an additional 6 cents/share earnings.
How this might affect the price of the stock in the marketplace is speculation, but if passed through in the form of dividends, at the current yield of 13.6%, this might mean an additional $0.35/share, which is the equivalent of a bad day in the overall marketplace, but still worth some consideration.
Now, the effects of the portfolio shift:
| Effect of Portfolio Rebalancing | |
| Current Portfolio | $ 141,000,000,000 |
| Current "Spread" | 1.02% |
| Current Interest Income/Year at 1% spread | $ 1,438,200,000 |
| 4Q Net Interest Income (Actual) | $ 761,265,000 |
| "New" Portfolio | |
| Current Stockholders' Equity | $ 17,000,000,000 |
| Stockholders' Equity remaining in RMBS | $ 12,750,000,000 |
| Stockholders' Equity in Non-Agency | $ 4,250,000,000 |
| Est Agency Portfolio at same leverage | $ 96,750,000,000 |
| Est. Income on Agency Portfolio at 1.05% Spread | $ 1,015,875,000 |
Keeping in mind that all looks into the future are filled with uncertainty, here is what is happening:
The current "spread" on NLY's government-backed portfolio is 1.05%, as of the last 10Q. The restructured business could use as much as 25% of shareholders equity to be in non-agency backed or commercial mortgages.
Using the same leverage of 7.59X, this would translate into an agency-backed portfolio of a little less than $100B, and at a 1.05% spread, which is what the company is currently getting, this would send a bit more than $1B to the bottom line.
For the "non agency" portion of the business, here is the calculation:
| Non-Agency Portfolio | High Case | Low Case |
| Leverage | 7.59 | 3 |
| Est. Non-Agency Portfolio | $32,250,000,000 | $12,750,000,000 |
| Est. Spread | 3% | 3% |
| Est. Interest Income, Non-Agency | $ 967,500,000 | $ 382,500,000 |
We are missing a piece of information, which is whether or not the conservative management of NLY will leverage the non-agency portfolio to the same degree as the agency-backed.
Not too long ago, we studied the case of Resource Capital Corporation (RSO) which is engaged mainly in commercial mortgage loans, and at about the same time, we were pointed to New York Mortgage Trust (NYMT) which has part of its portfolio in commercial loans. In both of these cases the management has leveraged the commercial mortgages to a lower extent than typical for government-backed residential, to compensate for the additional risk. The "spread" is the difference between the average portfolio rate and the interest expense.
So, the above analysis is a breakdown of what would happen with NLY's non-agency mortgages being leveraged at the current rate, and also, leveraged at a more conservative 3X. Note that I have assumed a higher 3% spread, as we would expect based on our previous analysis of what is going on in the commercial mortgage market.
So here is the calculation of the net effect of each scenario on the stock price:
| Non-Agency Portfolio | High Case | Low Case |
| Est New Interest Income | $1,983,375,000 | $1,398,375,000 |
| Est Net Interest Income Improvement | $ 545,175,000 | $ (39,825,000) |
| Est Net Interest Income Improvement/Share | $ 0.29 | $ (0.0215) |
| Dividend Pass Through Rate | 0.8 | 0.8 |
| Potential Dividend Increase/Share | $ 0.24 | $ (0.0172) |
| Potential Stock Price Effect @13.6% Yield | $ 1.73 | $ (0.13) |
In the "high case," the equally leveraged, more profitable non-agency mortgages at 25% of NLY's portfolio would send very nearly the same amount of money to the bottom line as the remaining RMBS portfolio. In the "low case," the effect on the bottom line would be slightly negative. Note: Just because the "low case," strategy might be slightly negative does not mean that the conservative NLY management wouldn't do it. The benefit to shifting the portfolio in terms of a lower repayment rate might make it worth it to them, from a portfolio stability standpoint.
So, here is the bottom line:
This refinancing strategy plus portfolio rebalancing has a chance to add anywhere between zero and $2.00 per share to the price of NLY stock, all other things being equal. At a current price of about $14.75 this would put it back up to where it was last summer, and represent about a 14% increase, in addition to the current dividend, which in light of the current amount of cash that NLY has on hand appears to be safe for a quarter or two at least.
Here are the unknowns:
Per the above, we do not know whether management will leverage the non-agency-backed portfolio at the same rate as the rest of the portfolio. Perhaps some bright analyst will ask this specific question of the management during the upcoming earnings telephone conference, which should happen in early January.
Secondly, we don't know exactly what the spread will be on NLY's non-agency portfolio. Our conservative 3% estimate above could be high or low.
Thirdly, we don't know the future direction of mortgage rates, and therefore how solid the company's current 1.05% spread is. Therefore, we don't know how solid the company's current stock price of $14.75 is. If we thought the housing market might be picking up, and that mortgage rates would be at least stable, we would feel better about the 3/4 of the portfolio that is going to stay the way it is. At the current rate of decline, the above $2 potential price improvement might only cause this to be a break-even type investment. Note: "Breaking Even" on the price for a stock that is currently paying 13.6% dividends looks like a pretty good investment.
There are a couple more things in favor of the investment: Right now, a little after mid-quarter, any investor who goes long can expect at least a 50-cent appreciation over the next few weeks in advance of the 50-cent dividend that will probably be announced on about December 19th, with an ex-divdend date of around December 27th.
Also in the grand scheme of things, it is likely that the current regime of low interest rates, Quantitative Easing and "The Twist" will continue. This is a piece of information we did not have a month ago. It also means that holders of capital will continue to be starved for yield, and the mREIT sector will get extra attention from investors who otherwise would not be anywhere near it.
As always, keep in mind that anywhere above where I say "if," "estimate," "potential" or "probably" is an opportunity for uncertainty. Also, keep in mind what we always say, which is that the world is full of chaos and there are no guarantees on anything.
But, be that as it may, there is a potential opportunity here, for those who wish to take it. Do with this information what you will.
Disclosure: I am long NYMT.
Additional disclosure: I also have a little portfolio of about 6 other mortgage REITs which I have been holding, patently collecting dividends despite the correction that happened this fall.
