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Annaly Capital Management (NYSE:NLY) reported its 4Q12 GAAP EPS of $0.70 beating street estimate of $0.36. EPS reported for 4Q12 was almost 52% higher than the EPS reported in 4Q11 and almost three times the EPS reported in 3Q12.

Summary:


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Source: Company Reports

Note: Net Income is in millions

Dissecting Annaly's Results:

(i) Net Income

Annaly was able to grow its GAAP net income at a phenomenal pace, as can be seen in the table. Adjusting the GAAP net income for unrealized gains or losses on interest rate swaps, Agency interest only mortgage backed securities and net loss on extinguishment of 4% convertible senior notes due in 2015, 4Q12 core net income increased by $15.3 million QoQ to $465.1 million but was still lower than 4Q11 core net income of $525.3 million.

(ii) EPS

GAAP EPS rose substantially, however in my opinion one's focus should be on core EPS which is based on net income adjusted for unrealized gains or losses. Core EPS marginally increased from 3Q12 and was down almost 15% from 4Q11. Earnings have been under stress since the fall in mortgage rates. Mortgage rates fell in response to Fed's QE3; Fed announced to buy $40 billion in mortgage backed securities a month. Therefore, decline in mortgage rates narrowed the net interest spread earned by mREITs. However, with sensible management and aggressive pursuit for diversification I believe that Annaly's earning will improve further in future.


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Source: Company Reports

(iii) Dividends

Dividend payout ratio dropped almost 13% from 111% in 3Q12 to 98% in 4Q12. The payout ratio in 4Q12 was almost 8% lower than the payout ratio in 4Q11. Although the payout ratio is still pretty high, declining payout ratio is an indication of low income return.


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Source: Company Reports

(iv) ROAE Core

ROAE has remained pretty stable over the last many quarters. Steady ROAE is a gauge for stable companies. ROAE in 4Q12 was 2% lower than ROAE in 4Q11 but was 50 bps better than ROAE in 3Q12, clearly a sign of improvement.


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Source: Company Reports

(v) Net Interest Spread

Net interest spread narrowed by 76 bps YoY and by 7 bps QoQ. Cost of funds remained stagnant over the last few quarters. The decline in spread was primarily because of reduction in yield on interest earning assets. Falling mortgage rates resulted in a decline in yields, fixed rate Agency mortgage backed securities and debentures comprised 93% of the Annaly's portfolio. I believe diversification, buying the remaining shares of Crexus Investment Corp. which specializes in commercial MBS, will improve spreads going forward.


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Source: Company Reports

(vi) Valuation

From a valuation stand point, NLY is trading at a discount of 6% from its book value per share as of Dec. 31st 2012. NLY was successful in growing its book value during 2012 except for the last quarter when it had to suffer a decline of almost 5% QoQ.


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Source: Company Reports

(vii) Constant Prepayment Rate

CPR in 4Q12 reduced to 19% from 20% in 3Q12. On a YoY basis, CPR reduced by 3% from 22% in 4Q11 to 19% in 4Q12. Consistent decline in CPR will benefit Annaly in quarters ahead. Reduction in prepayments will ensure stable earning going forward.

(viii) Leverage & Duration of Borrowing

Annaly is currently operating at leverage which is relatively lower as compared to its peers, 6.5x vs average 7.5x. Annaly has managed to reduce its duration of borrowing by 23 days QoQ but it is still on the high side relative to 4Q11. On a YoY basis duration of borrowing has increased by 87 days. Increase in duration means more interest rate risk.

Conclusion

Given the macro economic situation, mortgage rates rising with yield curve steepening and housing in a continuous recovery I believe net interest spreads will stable further, going forward. Under the given circumstances Annaly's recent decision to pursue aggressive diversification by acquiring Crexus Investment Corp. will work out well for it in future, in my opinion. Declining CPR and stable ROAE will translate into greater investor confidence in the stock. Although the dividend yield is currently lower as compared to its peers like American Capital Agency Corp. (AGNC) but I still find good value in the stock because:

1. I believe net interest spreads will improve further which will result in stable earnings and dividends going forward.

2. It is trading at a 6% discount from its book value.

3. There may be more share repurchases going forward which would result in further appreciation in stock price.

Based on my analysis I would recommend you to buy NLY.

Source: Annaly Capital Management, Inc. 4Q12 Results In A Snapshot