The worst is over for the Annaly Capital Management (NYSE:NLY) situation. At least, that is my opinion after covering the stock for some time. Following the most recent Q2 report, which I will discuss a bit here, I think the risk is to the upside from current levels. Those who follow my work and especially who own the stock realize that NLY has absolutely plummeted in 2013 in response to three key concerns. First was the fact that the Federal Reserve may slow or cease its mortgage asset purchases sometime this year. Second was the fear that rising interest rates will crush portfolio holdings of the mortgage real estate investment trusts (mREITs). Third, there have been some true issues with recent quarterly performance. In this article, I will discuss and put into perspective NLY's most recent quarter and lay out why I believe shares are undervalued and heading higher. After reviewing the quarterly report closely and being asked by several readers my overall opinion, I'd like to go over the key takeaways that investors, particularly those on the sidelines wondering if they should get in, should focus on when deciding for themselves if the negative price action in the stock is over.
Key Headline Statistics From Earnings; It Wasn't All That Bad
Unfortunately, a lot of traders and big money managers move stocks based on the headline numbers only. In essence, they shoot first, ask questions later. While I agree that the headline statistics, which for most companies are generally top and bottom lines as well as any future guidance, are important, they can be misleading at times. Overall, it looked pretty good. NLY reported a GAAP net income for the quarter of $1.6 billion or $1.71 per average common share as compared to GAAP net income of $870.3 million or $0.90 per average common share for the first quarter 2013. These numbers are even better compared to the comparable 2012 quarter, which was reported to be a net loss of $91 million or $0.10 a share. While this news is clearly good, we really need to look under the hood to understand where we are going from here.
The Spread on Interest Rates; Crucial To Profits
With interest rates moving wildly during the quarter ending in June, I had expected the interest rate spread for mREITs to actually improve as I predicted that the cost of borrowing would rise at a slower pace than the rise in yield being returned from investments. For the case of NLY, this proved to be true. The interest rate spread saw a slight increase quarter over quarter. To my pleasant surprise, NLY reported a net interest rate spread of 0.98%, which was a slight but meaningful change from the first quarter, which was reported to be 0.91%. This was a great sign for those who believe that the company may be stabilizing, but unfortunately, is still well below the 1.54% interest rate spread from the comparable quarter last year.
Let's look at this a bit more to see where the asset yields and costs of funds stand. First, NLY's asset yield on its interest earning portfolio for the quarter was 2.51%, compared to 2.37% for the first quarter. Not surprisingly, this is much lower than the yield in the comparable quarter of 2012. Although it is still diminished from 2012 levels, it was a marked improvement from Q1 2013 of 6% Furthermore, NLY's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 7 basis points to 1.53% for the second quarter, up from 1.46% for the first quarter, primarily due to higher average costs associated with entering into longer dated swaps during the quarter.
To put this all into perspective, the cost to borrow rose but the average yield on assets rose at higher absolute amount, leading to a higher interest rate spread quarter over quarter. Thus, earnings potential as a result of the interest rate spread has started to rebound. This statistic is one of the first things I examine when looking at the performance of any mREIT. Overall, it wasn't that bad, but still very weak versus 2012.
Is The Dividend Affordable?
While we have known about the declared dividend for a while when it was announced in June, let's look under the hood of this number a bit. I felt NLY could easily afford the dividend, but I was worried. The dividend of $0.40 per share was down 11% from the last dividend of $0.45 per share declared in the first quarter. It is also 27% lower than the Q2 2012 dividend of $0.55. It should be noted that this number was actually better than expected, as it was widely believed that the dividend was going to be cut to $0.35 or even as low as $0.25.
Looking under the hood a bit more, it would appear that the dividend was well within NLY's estimated taxable income per share of $0.47. Therefore, NLY did have sufficient cash and earnings to pay it. At a current share price of $11.60, this represents a still sizable yield that NLY has been known for, currently an annualized yield of 13.8%. It is important to note that this dividend can certainly fluctuate moving forward, but now that interest rate movements have calmed down, it is likely that we can expect this dividend to stay at current levels for the time being, if not improve.
Book Value A Critical Measure
I recently opined on the significance of book value for mREITs. Essentially, you want to buy when the stock trades below book value and sell when stock price gets too far ahead of book value. This assumes that book value will remain relatively stable, or in the case of buying below book value, will rise. With the extreme volatility over the last few months, quarter end book value was anyone's guess. But my readers know that I was adamant that NLY was probably trading well below book value. Well, as it turns out, book value dropped as expected, but as of June 30th the stock was indeed trading below tangible book value.
On June 30th, the stock was trading around $12.50. The book value was reported to be $13.03, which was a $2.16 drop from the end of Q1. However, it also meant that the stock was trading about 5% below book value, indicating at the time it was a good buy. Much of this decline was due to the volatility in mortgage-backed securities (MBS), and as such many investors and traders were just dumping the stock for fear that it could have been much worse. Considering the stabilization in MBS prices and interest rates over the last few weeks, we can likely safely conclude that book value has stabilized as well. Therefore, it is likely we are still trading at a significant discount to book value, and thus we still have a buying opportunity in the name.
What About The Role of The Federal Reserve?
Despite all of the volatility in the last few months, NLY has shown it can stand on its own two feet. For now, the worst is over. It was a transitional quarter and being a shareholder of mREITs has been painful since the beginning of 2013. I began accumulating and completing a position in NLY the whole way down. During this time, a lot of criticisms I received were surrounding the Fed and how devastating its exit will be. Upon the release of the June FOMC meeting minutes, it is clear that every member except one had advocated for an extension of the Fed's current economic stimulus program. This past week the Fed met once again, and their accommodative stance remains in place because the economic data just isn't that strong. The Fed simply is not advocating for tapering of asset purchases ahead of stable economic news and/or meeting the economic goals laid out when the program was announced, despite what occasional members may state. To me, the fears of this issue that punished the mREITs are simply unfounded right now. Among the most important takeaways is that the FOMC was adamant that the low-rate situation, or the zero rate interest policy, will not change until the unemployment rate drops to 6.5%. This is not likely until late 2014 or 2015.
The quarter was a significant improvement over the first quarter 2013. The headline earnings were pretty strong overall and showed improvement quarter over quarter. Investors should focus on two of the most important items to consider with the mREITs. First is the interest rate spread. It rose nearly 10% quarter over quarter. This is a crucial positive, especially for those who have been on the sidelines waiting to see if the company and subsequently the stock were stable. Right now, it appears the worst is over. To be certain, we should recognize that book value, the measure which should properly determine the share price of your mREIT and be used as a basis for deciding whether to buy or sell, was above the stock price at the end of the quarter. However, it declined significantly to $13.03 in just three months. As such, shares will be trading at fair value once they reach about $13.00 a share. Given that interest rates have stabilized and the company has undergone two transitional quarters, book value has likely stabilized around the $13.00 mark. Therefore, I believe shares are certainly still undervalued.