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Annaly Capital Management, Inc. (NYSE:NLY) is the largest mortgage real estate investment trust (mREIT) listed on the NYSE, with a market cap of ~$14.4 billion and assets on the balance sheet as of March 31, 2013, totaling ~$125 billion. NYL owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations (CMOs), callable debentures, and other securities backed by pools of mortgage loans.

The bulk of NLY's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or Ginnie Mae, and of corporate debt (together, "investment securities"). NLY relies primarily on short-term borrowings to acquire investment securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.

NLY's 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 encounter significant difficulties. Excerpts from the income statements for the quarters ending March 31, 2013, and March 31, 2012, and for the trailing 12 months (TTM) ending on those dates, illustrate some of these difficulties:

Click to enlarge images.

Table 1: Figures in $ Millions

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 Table 1 above. The unrealized gains and losses on investment securities show up only on the balance sheet, not the income statement. Unrealized gains (losses) on interest rate swaps are treated similarly. There are also reclassification adjustments for income statement losses (gains) that reduce comprehensive income. Therefore, I find NLY's reported earnings, earnings per share, and earnings multiples to be of limited value as indicators of performance or of ability fund dividends from sustainable distributable cash flow (DCF).

The cash flow statement presents another illustration of the difficulties encountered in trying to ascertain whether you are genuinely receiving a yield on your money (rather than a return of your money). NLY reports cash flow from borrowing and lending via repurchase and reverse repurchase agreements (repos) as cash flows from operating activities when these activities 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, as a first step I developed a simplified cash flow statement designed to shed light on the sustainability of the dividends. This simplified statement groups together and aggregates numerous non-cash line items that deal with losses (gains) on assets and liabilities reported in the income statement. It also aggregates proceeds from, and payments for, numerous types of assets and liabilities, 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, and e) equity investments (including investments in affiliates). This reduces the over 50 line items in NLY's cash flow statement to just a few and provides an initial estimate of cash generated by potentially sustainable sources.

Table 2: Simplified Cash Flow Statement (Figures in $ Millions)

Of course, the net increase (decrease) in cash in Table 2 ties to the number in the company's financial statements. Some items such as asset sales and equity/debt offerings are clearly not sustainable sources of cash. The question is what portion of the items grouped under "Cash from potentially sustainable sources" in Table 2 is indeed sustainable? The second step of my analysis derives that portion by looking at net interest income and then deducting expenses as a proxy for NLY's sustainable DCF, as presented below:

Table 3: Figures in $ Millions, Except DCF Coverage

The dividend reductions enabled NLY to show small surpluses of sustainable DCF for the periods under review. It seems that management has aligned its dividends to what NLY can sustain. This analysis is somewhat conservative in that it ignores non-interest income items such as investment advisory and other fee income, dividend income from affiliates and income generated from trading assets. But I do not consider these to be at the core of NLY's business and therefore exclude them from the sustainability analysis.

Table 3 indicates the dividends have been "earned" in the sense that they have not been financed by issuing debt or equity or via asset sales. However, it does not give a good enough view as to what is happening to NLY's basic business model. The next step in the analysis is presented below:

Table 4

NLY's bread and butter business of using short-term borrowings to acquire mortgage-backed securities and debentures issued by U.S. government agencies (Fannie Mae, Freddie Mac, or Ginnie Mae) is modeled in Table 4. The basic problems facing NLY in executing the model are highlighted in the charts below.

First, net interest rate spreads are shrinking:

Second, book value has dropped, primarily as a result of large mark to market losses in the last quarter:

As shown by the model in Table 4, the combination of drop in net interest rate spreads and book value is a "double whammy" for NLY. It has been somewhat compensated for by the increase in leverage, which is readily observed:

However, as the Table 4 model shows, increased leverage did not provide sufficient firepower to overcome the adverse effects of two factors previously mentioned. In any event, higher leverage increases risk for equity investors and will drive up cost of capital. A particularly sharp decline in NLY's interest rate spread came in September 2012. This followed the Federal Reserve's Sept. 13, 2012, announcement of QE3, the Federal Reserve's launch of a new $40 billion a month, open-ended, bond purchasing program of agency mortgage-backed securities -- thus directly competing with NLY and driving up the prices (and driving down the yields) of precisely the types of securities NLY seeks to purchase. This was followed by a sharp decline in NLY's stock price.

Now there are indications the Federal Reserve will reduce its bond purchase program. It seems to me that this is driving down prices of mortgage backed securities (despite the low interest rate environment) and is the main reason unrealized losses increased substantially and book value declined. While this exerts further downward pressure on NLY's stock price, there could be a silver lining in the form of improved net interest spreads resulting from reduced competition for the assets being sought by mREITS such as NLY.

My personal bottom line is "Hold." I do not intend to significantly change 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 to real estate assets other than agency mortgage-backed securities -- via the acquisition of Crexus Investment Corp. (NYSE:CXS) -- could make a positive contribution. But it presents a significant shift to a yet unproved business model and, like the increase in leverage, entails considerable risks.

Source: Can Annaly Capital Management's 12.2% Dividend Be Sustained?