In a prior article I outlined a methodology for assessing the dividend sustainability of a mortgage Real Estate Investment Trust ("mREIT"). I now apply this methodology to Annaly Capital Management, Inc. (NYSE:NLY) and examine its dividend sustainability in light of the recent earnings report covering 2Q13.
NLY is the largest listed on the NYSE with a market cap of ~$11.8 billion and assets on the balance sheet as of 6/30/13 totaling ~$102 billion. NLY 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 (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) 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 ~13.4%. 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." The first significant difficulty faced by an investor trying to answer this question is encountered when attempting to analyze key business parameters within NLY's income statement, as outlined in Table 1 below. Given the significant quarterly fluctuations, Table 1 includes trailing 12 months ("TTM") figures in addition to the quarterly numbers.
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. 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 second significant difficulty faced by an investor trying to ascertain whether the dividend yield is sustainable is a cash flow statement exceedingly complex and difficult to decipher. For example, NLY reports cash flow from borrowing and lending via repurchase and reverse repurchase agreements ("repos") as cash flows from operating activities when RCap (NLY's wholly owned broker-dealer subsidiary) is a party to the transaction. But other repos 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.
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; and d) principal payments on, or maturities of, securities owned. This eliminates a considerable portion of the ~64 line items in NLY's cash flow statement and provides an initial estimate of cash generated by potentially sustainable sources. Of course, the net increase (decrease) in cash in Table 2 ties to the number in the company's financial statements.
Simplified Cash Flow Statement:
Table 2: Figures in $ Millions
I do not consider items below the Subtotal line as 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 in Table 3 below:
Table 3: Figures in $ Millions, except DCF coverage
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.
On another level, however, the analysis is not conservative enough. This is because the GAAP measurement net interest income does not include all the expenses of interest rate swaps. Management refers to net interest income, including interest expense on interest rate swaps, as "economic net interest income."
Since GAAP results do not give a good enough view as to what is happening to NLY's basic business model, and since economic net interest income is a more meaningful and useful measure, the next step incorporates this factor and the results are presented in Table 4 below:
Table 4 provides a simple model describing 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 model highlights the basic problems facing NLY: net interest rate spreads are dropping, and book value is shrinking. This "double whammy" causes an increase in leverage, also readily observed in Table 4. Absent the higher leverage, the decline in earnings on interest bearing assets would have been sharper. But higher leverage increases risk for equity investors and drives up cost of capital. And in spite of the higher leverage, sustainable coverage of dividends is still insufficient. Dividends have been reduced, but they are still not aligned with what NLY's basic business model can produce under 2Q13 conditions.
My personal bottom line following the analysis of NLY's 1Q13 results was "Hold." The stock was at $14.50 and closed at $11.94 on 8/9/13, so clearly a decision to sell would have been wiser. I added to my position during the sharp price declines in May-June, but am now leaning towards selling all or a portion of my position. On the positive side, net interest margins in 2Q13 showed an increase for the first time in 7 consecutive quarters, prepayment rates have declined from their year-ago levels, and management seems to have aligned its dividends to what NLY can sustain. On the negative side, the current dividend level does not seem sustainable (absent a significant improvement in the business model parameters. Also, there has been a significant increase in leverage, a diversification into commercial real estate assets via the acquisition of Crexus Investment Corp. that presents a significant shift to a yet unproved business model, and a recent structural change (that I strongly dislike) following which NLY is managed by a separate firm that employs its former executives.
Disclosure: I am long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.