In response to a more adverse business environment, Annaly Capital Management, Inc. (NLY) has been reducing its dividend:
Figure 1: NLY dividends
The most recent dividend announcement occurred on December 18, 2012, and the amount was reduced from $0.50 for 3Q 2012 to $0.45 for 4Q 2012 (payable 12/24/12).
NLY currently yields ~12.2%. However, investors familiar with my approach know the first question I ask is what portion, if any, of the dividends I am receiving are really "earned." I am leery of investing in entities (publicly traded partnerships or companies) that pay dividends, or fund distributions, by issuing debt or additional equity.
In taking a closer look at NLY, I encountered difficulties similar to those I faced when reviewing the performance of MLPs. Since money is fungible and NLY's annual report runs over 100 pages that are frequently hard to understand, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.
Several examples can illustrate the complexities. NLY's Investment Securities are classified for accounting purposes as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. The effect can be dramatic, as seen in 3Q 2011 when reported losses (realized and unrealized) amounted to 38.8% of the average equity and NLY's net loss for the period amounted to ~$926 million. But there were $1.1 billion of unrealized gains in that quarter that showed up only on the balance sheet, not the income statement. Another example is the subjectivity involved in determining net interest margin, an important performance indicator. Beginning June 30, 2011, NLY reclassified "interest expense on swaps" to "realized gains (losses) on swaps" thus changing the way net interest margin is calculated, Therefore, I find NLY's net interest margins, reported earnings, earnings per share and earnings multiples to be of limited value as indicators of performance or of ability to generate sustainable dividends.
The treatment of borrowing and lending via repurchase and reverse repurchase agreements ("repos") is yet another example. NLY reports cash flow from these activities as cash flows from operating activities when they are performed by RCap (NLY's wholly-owned broker-dealer subsidiary), but when they are not performed by RCap, they appear as cash flow from investing activities. Therefore, I find NLY's distinctions between the various categories on the cash flow statement (i.e., operations, investments and financing) to be of limited value in understanding NLY's ability to generate sustainable dividends.
In light of these issues, I created a simplified cash flow statement designed to shed light on the sustainability of the dividends by, for example, grouping together and netting out numerous line items that deal with gains and losses that are reported in the income statement but are non-cash items (and therefore reversed out in the cash flow statement). I also separate cash generation from cash consumption and group together and net out numerous line items that deal with cash outflows for assets (e.g., acquiring assets outright or receiving assets as collateral and lending against them) and cash generated by assets (e.g., selling assets outright or giving assets as collateral and borrowing against them). This reduces the over 50 line items in NLY's cash flow statement to just a few and provides an initial indication of whether distributions are funded by asset sales and or equity/debt offerings. Results for the quarters ending 9/30/12 and 9/30/11, and for the trailing twelve-months ("TTM") ending on those dates, are outlined in Table 3 below:
Simplified Cash Flow Statement:
Table 3: Figures in $ Millions
In these simplified cash flow statements, proceeds from, and payments for, assets contain numerous types of netted items, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; d) principal payments on, or maturities of, securities owned; e) equity investments (including investments in affiliates). Of course, the net increase (decrease) in cash and cash equivalents ties to the company's financial statements.
Asset sales and equity/debt offerings are clearly not sustainable sources of cash and, according to Table 3, should not be considered as having funded NLY's distributions. But what portion of the other Table 3 items grouped under "Cash from potentially sustainable sources" is indeed sustainable Distributable Cash Flow ("DCF")?
My preference is to use net interest income as a proxy for NLY's sustainable DCF. One way to do this analysis is presented in Table 4 below:
Table 4: Figures in $ Millions
The shortfall for 3Q 2012 indicated in Table 4 amounts to ~10% of the amounts distributed. Since 4Q 2012 dividend was cut by 10% (from $0.50 to does $0.45 per share), it seems that management has aligned its dividends to NLY's sustainable DCF.
Another way to estimate sustainable DCF based on net interest income, presented in Table 5, indicates sustainable DCF of approximately $0.36 per quarter.
Table 5: Sustainable dividend yield
Based on Tables 4 and 5, my assessment is that sustainable DCF is at, or perhaps ~10% below, the current distribution rate assuming, of course, no further deterioration in net interest margin.
In light of the current market environment and deteriorating net interest margins, on 11/12/12 NLY unveiled a plan to diversify its asset base of predominantly portfolio mortgage-backed securities issued by U.S. government agencies (Fannie Mae, Freddie Mac, Ginnie Mae) by acquiring ~87.6% of commercial property investor Crexus Investment Corp. (CXS) for ~$825 million (NLY already own ~12.4% of CXS). Management noted it may allocate up to 25% of NLY's ~$17 billion shareholders' equity to real estate assets other than Agency mortgage-backed securities. The allocation to such assets as of 3Q 2012 is ~6%.
Despite the drop in price and still high dividend yield, I do not intend to significantly increase my NLY position. The current market environment (narrowing net interest margins and high prepayment rates) remains very difficult for mREITS such as NLY. I do not see this changing in the near future. A significant increase in leverage and the diversification move could make a positive contribution but present a significant shift to a yet unproved business model, and both entail considerable risks.
Disclosure: I am long NLY.