By Siraj Sarwar
Annaly Capital Management (NLY) is a real estate investment trust which invests in mortgage pass-through certificates. The company has a relatively simple business model. It invests in collateralized mortgage obligations, and other mortgage-backed securities.
As one of the most popular mREITs, Annaly is known as one of the top dividend payers in the industry. The company greatly benefited from the low-interest atmosphere we experienced in the last decade. However, as the interest rates reached their historical lows, there is a great concern whether Annaly can keep paying its distributions. Amidst these concerns, Annaly also announced a share repurchase program.
In this article, I look at the company's distributions and on its financial position to discuss the dividend sustainability. I also look at the share repurchase program announced in the last quarter.
Annaly has a long history of dividend payments. According to NASDAQ, the company paid quarterly dividends since 2000. Currently, the company offers cash dividend of $0.45 per share, yields at 13.81. At the end of Q3, the company generated $7.28 billion in operating cash flows and paid $1.64 billion in dividend payments.
The company's revenue generation is simple. Annaly generates net income from the spread between the interest income on interest-earning assets and the costs of borrowing to finance the acquisition of interest-earning assets. Principal payments and interests on the company's investments are assured by the government-sponsored agencies such as Freddie Mac, Fannie Mae, and Ginnie Mae. The company also receives dividends from its subsidiaries. The company's wholly-owned subsidiaries offer diversified real estate, asset management and other financial services.
However, Annaly's business model strongly depends on the government policies, especially the monetary policy. Annaly is highly dependent on Federal Reserve's policies. Recently, the company's stock dragged down due to the Federal Reserve's third round of quantitative easing. I feel Annaly is strong enough to face strong headwinds. The company has a strong balance sheet together with huge cash flows to sustain dividends. Even the company survived the housing market meltdown in 2008 and 2009.
At the end of Q3, The Company's net income was $224.8 million or $0.22 per share, compared to a net loss of $921.8 million for the Q3 of 2011. Annaly's net income increased by $1.1 billion in the Q3, compared to the Q3 of 2011. The company's profits increased due to the decline in unrealized losses on interest rate swaps of $1.4 billion. However, Annaly is not producing consistent margins due to the dependence on external polices. In the last twelve months, the company produced operating margin of 85.63%, well above from 2010 and 2011. Annaly's business model strictly depends on government authorities; therefore its dividends are also not consistent.
How Share Repurchase Program Can Help Investors
Annaly announced a share repurchase program of $1.5 billion on October 16. I believe both dividends and share buy-backs can increase the share price. Dividends put in value by distributing cash to shareholders, and buy-backs also increase the value by reducing the number of shares in the market. I usually keep my focus on dividends rather than the stock price. However, I am also giving my brief view on the price of stock in response to share repurchase program.
Research discovers that small repurchase programs create an average share price increase of 2% to 3%. Larger buybacks produce an average share price increase of 15% or more. Moreover, buybacks generally offer positive affect on the share prices. By decreasing the supply of outstanding shares when the demand remains unchanged, buybacks can increase the share price. The decreased share count can also induce an increase in per-share dividends, thus helps raise the share price. Above all, a buyback indicates that management feels the stock is undervalued.
Mortgage-backed REITs executed well in the first ten months of fiscal 2012, in comparison with the last year. However, from October, REITs started to see downward movement to the end of the year due to Fed's QE3 announcement. For the full year, big mortgage REIT players like American Capital Agency Corp (AGNC) and Annaly Capital Management were up only +2.92 percent and down -12.03 percent, respectively. Because of the inconsistent interest rates, these firms have had to reduce dividends.
High mortgage rates can be a beneficial for mortgage REITs, but they bring a negative aspect as well. If a mortgage rate continues to fluctuate, this probably means investors will begin to see massive fluctuations in mortgage REIT prices in the short-run. Since these firms are engaged in such a volatile market, they usually not sustain a consistent dividend payment every quarter. On the other hand, a higher mortgage rate means that these REITs will see larger returns from the mortgages. If the cash they borrow to buy these mortgages is at a low rate, the spread could raise. The big spread means stockholders are going to receive higher returns.
Annaly is now seeking to diversify its portfolio by purchasing CreXus Investment (CXS). CreXus is a commercial real estate firm with an identical business model of purchasing debt obligations and commercial loans. This purchase will give Annaly exposure to commercial mortgage-backed securities along with residential mortgages.
The Fed has become a large rival to the already-crowded mREIT market. The stock prices of many companies like American Capital Agency, Chimera Investment (CIM) and CYS Investments (CYS) went down substantially since the launch of QE3. The Fed's mortgage-buying has diminished the interest rate spreads that forms the backbones of mREITs' business model.
Nevertheless Annaly is well positioned to cope with these strong headwinds, including fiscal cliff talks. Annaly has sufficient amount of free cash flows and have stronger balance sheet than most of its peers.