Annaly Capital Management Inc. (NYSE:NLY) is a mortgage REIT. It has historically been a large investor in agency residential mortgage-backed securities (RMBS). However, this may be changing with its recently announced proposal to acquire CreXus Investment Corp. (NYSE:CXS). Although CXS is externally managed by the Fixed Income Discount Advisory Company (FIDAC) -- a wholly owned subsidiary of NLY -- the acquisition of CXS would still be a significant expansion of NLY into the CMBS and the non-agency RMBS areas.
At the time of this announcement, NLY already owned 9,527,778 shares of CXS -- about 12.4%. The CXS buyout is an expansion of NLY's effective portfolio into riskier, wider interest rate spread securities. It makes a lot of sense in the current extremely narrow interest rate spread agency RMBS market. It makes more sense when you realize NLY has recently sold some of its agency RMBS to capture their currently high market value premium to face value. When you do this, you don't necessarily want to jump right back into the same securities that are likely overpriced for anything but the shortest time period. Expanding into CMBS and non-agency RMBS makes a lot more sense. And NLY did specifically say it intends to do this beyond the CXS buyout.
NLY has also approved a stock buyback program of up to $1.5 billion of its outstanding shares over a 12-month period for likely the above-mentioned reason (Oct. 16, 2012). Many consider stock buybacks a sign of weakness in a company. However, in this case it is more likely a sign of good management. NLY is taking good profits from the sale of currently high premium to face value assets. It has to do something with the money.
Long-term U.S. Treasury bond rates have already started to rise. The 30-year U.S. Treasury yield is up from 2.72% on Nov. 13, 2012, to 3.09% on Jan. 8, 2013. Meanwhile, the 30-year fixed-rate mortgage is relatively unchanged at 3.43% as of Jan. 8, 2013, over the same time period. However, mortgage rates will not likely be far behind. Taking profits on premium valued assets is highly preferable to taking big losses when the mortgage rates go up (when the premium decreases). NLY can easily raise more money through stock offering(s) when this situation improves. NLY is hedged to prevent huge book value losses from this case. Still decreasing its exposure, while simultaneously taking great profits, makes sense. To get an idea of the proportions of the above moves relative to NLY's holdings, NLY's market cap is $14.29 billion. Its enterprise value is $115.22 billion. It had $129.6 billion in agency MBS at the end of Q3. Of these, 93% were fixed-rate MBS and 7% were adjustable-rate MBS. The leverage at the end of Q3 was 6.0-to-1 vs. the leverage at the end of the year-ago quarter of 5.5-to-1. The selling for profit of $7.3 billion in agency MBS is a minor blip in these holdings. It moves NLY back toward its less risky leverage ratio of 5.5-to-1 at the end of Q3 2011.
Looking at NLY's Q3 earnings, the company swung to a profit of $224.76 million for Q3 2012 (or $0.22 per common share) vs. the year-ago result of a net loss of $928.1 million, or -$0.98 per common share. NLY reported no net revenue for the quarter. These data amount to a weak result, but the interest rate spread is bound to widen soon with the ending of Operation Twist as of Dec. 31, 2012. A wider interest rate spread will eventually mean more interest rate spread profits for NLY (and other agency mortgage REITs). Furthermore, NLY's results were not as weak as they appear to be on the top and bottom lines. Excluding the effect of unrealized gains or losses on interest rate swaps and agency interest-only MBS, and the net loss on the extinguishing of the 4% convertible senior notes due in 2015, net income for Q3 2012 was $449.8 million, or $0.45 per common share. This was still lower than the $0.65 per share of the year-earlier quarter and the $0.55 per share of Q2 2012. But it was a quite reasonable result given the recently narrowed interest rate spreads.
In sum, the results were acceptable and the planned acquisition of CreXus will allow NLY to move more fluidly into investment in CMBS and non-agency MBS (perhaps in NLY's own portfolio). CXS fits nicely into NLY's group of partially and/or fully owned subsidiaries. These include RCAP Securities (a FINRA Broker Dealer), Merganser Capital Management (an SEC Registered Investment Advisor), Shannon Funding (Warehouse Lending), FIDAC Registered Investment Advisor (an SEC Registered Investment Advisor), Charlesfort Capital Management (Middle Market Lending), Chimera Investment (NYSE:CIM) -- a NYSE-registered corporation -- and CreXus Investment, a NYSE-registered corporation. The CXS acquisition seems a strong step in the right direction for the times ahead. The Fed is strongly supporting U.S. housing market. The "riskier" areas of the real estate industry in which CXS invests should be highly profitable (and less risky) as the U.S. housing market slowly and steadily recovers.
The two-year chart of NLY provides some technical direction for this trade.
Click to enlarge image.
The slow stochastic sub chart shows that NLY is approaching overbought levels in the short term. The main chart shows that NLY has been trending downward since October 2012. Logically, this downtrend was likely associated the QE3 and QE4 caused narrowing of the interest rate spreads. The interest rate spreads seemingly bottomed at an average spread of 1.02% for NLY in Q3 2012. At the end of Q3, the average interest rate spread had rebounded to 1.24%. This is still a far cry from the Q3 2011 spread of 2.08%. However, with the U.S. 30-year Treasury yields rising and Operation Twist now over, NLY's interest rate spreads seem likely to rise significantly. NLY's profits should rebound in future quarters. With a current price/book ratio of 0.88 and a still-great dividend of 12.30%, NLY looks like a buy going forward.
The average analysts' recommendation on NLY is 3.0 (a hold). However, the large brokerage analysts are often behind the curve in cases like this. They typically wait until stocks show more definitive up moves in financial data. The CAPS rating of four stars is probably a better assessment of NLY's near-term prospects. Even with a possible recession coming in 2013 for the U.S., NLY -- with the Fed backing the real estate industry -- should be one of the safer places to have your money. Plus, many investors may buy it (or buy it back) after the relatively benign fiscal cliff settlement on dividend taxes by Congress. Dividend taxes for the rich on dividends were only raised from 15% to 20%. They were not raised at all for families making less than $450,000.
NLY is an REIT. It has distributions instead of dividends. However, it still suffered from the same dividend stock sell-off. Many people simply do not differentiate between distributions and dividends. NLY should see many investors buying it or buying it back in 2013. Since it also appears to be a great bargain (P/B of 0.88) with likely improving business prospects and dividends/distributions, investors will have that much more reason to buy it. Rising U.S. Treasury yields (losses in value of Treasury bonds) are a good reason many income investors will likely consider NLY instead of money-losing bonds. Some are even predicting a bond crash for 2013. NLY's beta of only 0.06 in a very uncertain time may be another good reason to buy it. NLY has already announced its dividend of $0.45 for Q4 2012.
Note: Some of the fundamental financial data above is from Yahoo Finance.