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. (NLY) and examine its dividend sustainability in light of the recent earnings report covering 3Q13.
NLY is the largest mREIT listed on the NYSE with a market cap of ~$9.8 billion and assets on the balance sheet as of 9/30/13 totaling ~$93 billion. NLY owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations ("CMOs"), callable debentures, other securities backed by pools of mortgage loans and commercial real estate assets.
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 the 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 currently yields ~13.5%. 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.
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 to 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 & 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 ~50 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:
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:
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 net interest income as measured by GAAP does not include all the expenses of interest rate swaps. Management's non-GAAP definition of net interest income includes all expenses on interest rate swaps and is referred to as "economic net interest income." This measure is derived by deducting economic interest expense from interest income, as shown in Table 4:
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 measure into the analysis and the results are presented in Table 5 below:
Table 5 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). The model highlights the basic problems facing NLY: declining net interest rate spreads, lower levels of interest-bearing assets, and steep drops in book value. Despite reducing dividends, sustainable coverage in 3Q13 and the TTM ending 9/30/13 is below the 1.0 threshold. It has been so for the past 8 quarters. The reduced dividend level is still not aligned with what NLY's basic business model can produce under 3Q13 conditions. Management could try to address this by increasing the amount of interest-bearing assets supported by each dollar of equity, but higher leverage will increase risk for equity investors and drive up cost of capital.
On the positive side, net interest margins in 2Q13 showed an increase for the first time in 7 consecutive quarters and increased again, if only slightly, in 3Q13. Also, prepayment rates have declined from their year-ago levels. However, the interest rate spread is still much narrower than the levels achieved through mid-2012. While management continues to reduce dividends in an attempt to align them to what NLY can sustain, the latter is falling faster than the former. Of course this could change with a significant improvement in the business model parameters, but I don't see that on the horizon. In addition, there has been a significant diversification into commercial real estate assets via the acquisition of Crexus Investment Corp. An effort is underway to diversify even further, although no details have been provided. These moves present a major shift to a yet unproved business model. Finally, a separate firm now employs NLY's management team following a recent structural change that I strongly dislike.
My personal bottom line following the analysis of NLY's 2Q13 results (published 8/12/13) was "Sell." The stock was at $11.97 and closed at $10.42 yesterday (11/20/13). Having not so wisely added to my position during the sharp price declines in May-June, I avoided a greater loss by selling a portion of my position after completing my analysis of 2Q13 results. I will continue to reduce my position because I do not see any imminent prospects of an improved environment, and specifically a steeper yield curve that would result in higher net interest margins for mortgage-backed securities that form the bulk of NLY's portfolio.