Doom And Gloom Or Clear Skies? What To Expect From Annaly's Upcoming Report

| About: Annaly Capital (NLY)

At the most basic level, the last few weeks of the third quarter and the start current fourth quarter have provided an environment that has been quite strong Annaly Capital Management (NYSE:NLY). On the surface, things are looking much improved in recent weeks after the absolute massacre that has occurred in share price which led to several cuts to dividends paid in 2013. Yet, the stock is down about 3.6% to $11.70 this week at the time of this writing because it, along with other mortgage real estate investment trusts (mREITs), got hammered after their large competitor American Capital Agency (NASDAQ:AGNC) took a nose dive after reporting what was considered by the street to be a rather weak quarter. The headlines were indeed bad as AGNC reported a third-quarter loss of $1.80 a share, compared to analysts' consensus expectations of $0.77 per share, but was offset by $2.25 in other comprehensive income. Overall, AGNC cited continued volatility in interest rates and motile mortgage spreads for the earnings weakness, two factors which are indeed critical for mREITs to thrive. I believe that the quarter wasn't as bad as it seems in the headlines, due to the fact that the climate for mREITs has turned around as the third quarter ended and the fourth quarter began. In fact, I consider it a buy at current levels, especially since I believe book value is on the rise this quarter. A nice analysis of the strengths of AGNC's quarter and why it is a buy can be found here in an elegant piece by fellow contributor David White. In this article I would like to discuss what I will be looking for when NLY reports its quarter, which will allow investors to prepare and react appropriately.

The Key Items To Look For In The Q3 Report

NLY will release its third quarter on Monday November 4th, 2013. In light of the damage to mREIT shares following AGNC's report, there is a lot of fear among NLY shareholders right now. What is important to realize is that we must still focus on the key metrics of the company to gauge its strength. Perhaps more importantly will be what management says about the current state of the company in the current quarter. I believe all investors should examine the measures I will outline that will give a strong indication as to whether my thesis that things are improving is correct.

We really want to hone in on some of what I have discussed in various pieces in the last three months as being important as well as focus on issues cited by competitors. The most recent NLY earnings report for the second quarter followed the general trend of disappointing results in the mREIT space. Considering that AGNC's quarter was weak, as were reports by Javelin Mortgage (NYSE:JMI) and Armour Residential (NYSE:ARR), it could be a disappointing report, at least on the surface. Before anyone reported, I thought that the current quarter could go either way. Now, just because others underperformed does not necessarily guarantee that NLY's quarter will be just as bad, but it seems that the street is pricing the stock as if it is likely to be a painful quarter. The dividend cut was also a sign of potential trouble brewing ahead. Despite these facts, the key points of the report that I will highlight will help provide clarity on what the company experienced in the quarter and may give an indication as to the future health of its portfolio holdings.

The following Q2 metrics are what is key to look for during the Q3 report, in my opinion. First off, NLY reported a Q2 GAAP net income of $1.6 billion, or $1.71 per common share. What I would love to see management provide is a calculation/estimate of taxable income, as this is really key to profitability and more importantly, what they have to or can afford to pay in dividends. The company needs to post further gains, but with competitors posting a loss, it may be weaker than expected. It certainly cannot afford to report a losing quarter. However, the company did manage to stay in the green in Q2 while others were bleeding in red. This is a vote of confidence in the management. However, with the spike in rates in July and August and the quarter could be painful as this is just so difficult to overcome. We can look to the performance of hedges that are in place, but me mindful that these hedges will have to perform brilliantly cover the losses in MBS value that occurred in those first two months It is not impossible. AGNC reported $0.45 in comprehensive income per common share and this was comprised of a $1.80 net loss per common share and a $2.25 other comprehensive income gain per common share as a result of hedging. Now, despite the gloom that could be ahead on the performance front, I believe that a weak quarter is baked into the stock price. We could get an in line or better than expected quarter, which certainly would boost shares.

AGNC reported that the net interest rate spread also increased from 1.24% at the end of Q2 to 1.37% at the end of Q3, those this figure was hampered by the dollar roll income/loss. For NLY in Q2, the annualized yield on average interest-earning assets was 2.51% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.53%, which resulted in an average interest rate spread of 0.98%. This was a 7 basis point increase from the 0.91% average interest rate spread in Q1. The company deleveraged down to 6.2:1 in Q2 from 6.6:1 in Q1. We learned that AGNC did not lever up in the quarter, so I am very interested to see if NLY management, which has historically been conservative, decided to take on more risk. Based on other reports, movement of interest rates in the quarter and the impact on MBS, I estimate the Q3 interest rate spread to be 0.93% to 1.02%. I will also be looking at the constant pre-payment rate which has declined in the last two quarters from 18% to 16%. Finally, book value drives share price. As we know, it has been hammered in 2013. In the last quarterly report book value was $13.03, down from $15.19 in the first quarter. AGNC reported a book value of $25.27 per share, less than a 1% decline from its book value at the end of Q2. This metric provides evidence to my thesis that the companies are stabilizing. I imagine it may be higher as October has been favorable. With the increase in rates to start the quarter followed by the favorable shift in September, I am looking for a similar decline in NLY's book value of 1% to 4%. I will be looking at the performance of each of these metrics, but most important will be to listen to management's commentary about the changing environment.

How to Prepare

I think it is foolhardy to sell ahead of earnings. I believe a mediocre to weak quarter is priced into the stock. At $11.70 per share the stock is almost guaranteed to be trading at a discount to book value at the end of Q3 and I believe book value has risen to start Q4. Once we get a look at performance, we will have a better idea of where the dividend stands. Based on current performance and pending a decent Q3 report, the dividend will be maintained in Q4 when they announce the distribution. With a current 11.7% yield and a favorable macro environment, the stock is setting up nicely for a bounce off these recent lows as we head into the end of the year. One final point I would like to make is on the Federal Reserve. The Fed simply has not advocated 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 taper/no taper issue that punished the mREITs are simply unfounded. With Janet Yellen receiving the nod for the Chairman of the Board, dovish policies are likely to continue. Among the most important thing to remember is that the FOMC has been 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. Finally, with the rebound in housing being so fragile, I believe the Fed will do all it can to keep rates low for borrowers until there is a much stronger confirmation of an improving economy. Thus, the mREITs are likely to benefit.

Disclosure: I am long AGNC, JMI, 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.