What Is Annaly's Dividend Payout Over A Full Business Cycle?

| About: Annaly Capital (NLY)


Annaly currently trades at a 3-5% discount to book value, which puts the mortgage REIT on the radar of value investors.

The last time Annaly offered investors a 10% starting yield before the financial crisis, it gave investors $1.18 in dividend income on every $1 invested over ten years.

However, this stock is almost certainly not for everyone, as volatile earnings and steep dividend cuts are an inevitable reality of this company's business cycle.

At $11.64 per share, Annaly Capital (NYSE:NLY) is surely starting to show up on the radar of investors that are truly interested in accomplishing two objectives: (1) owning a stock that is going to produce a lot of income over the full course of a business cycle, and (2) is undervalued. Given that Annaly suffered a significant decline from the price of $16.20 last year to the current price of $11.64 that is below the company's 2013 book value price of $12.13, it's worth asking the question, "Is Annaly a company that offers the realistic potential to achieve significant capital appreciation and total income over the next 5-10 years?"

I understand that the simplistic concern with Annaly is to say, "Oh, interest rates might rise in the future, and that means this stock will suffer substantially, as if by definition." But that kind of thinking ignores the preparation efforts taken by Annaly management to prepare for a rate rise, and the current discount to book value offered by the shares.

Let's take those one at a time.

First of all, Annaly wrote down 40% in assets, many of which were agency mortgage-backed securities that carried a higher risk of getting affected Annaly is no longer able to borrow at a stagnant or declining low short-term interest rate to make longer-term investments. To speak about it specifically, after loading up on mortgage loans per share throughout the financial crisis (Annaly's mortgage loans per share figure increased from $118 per share in 2009 to $134 by the end of 2012, before clearing out the underbrush in 2013 and reducing the mortgage loans per share to $77 per share). Sure, that kind of ratcheting has unpleasant side effects, as long-term holders experiencing the $2.05 dividend in 2012 decline to $1.50 in 2013 can tell you).

Not only has Annaly improved the quality of the mortgage loans per share by removing from its balance sheet many of the potentially problematic loans that would crop up down the road, but they have modified their strategy to adjust for the fact that expected increases in short-term interest rates (and thus, higher borrowing rates for Annaly) can be offset by selectively adding commercial real estate to the loan portfolio (commercial real estate loans produce higher returns that government-backed mortgage securities, this diminishing the pain to shareholders that a rise in short-term borrowing rates would cause).

As we learned last month:

"Annaly will purchase commercial properties of a certain size and profile sourced and managed exclusively for Annaly by affiliates of The Inland Real Estate Group of Companies, Inc. ("Inland")… This initiative further augments Annaly's continued expansion of its commercial real estate portfolio. As of March 31, 2014, Annaly owned approximately $1.7 billion in commercial real estate assets, an increase from $1.0 billion at June 30, 2013."

This has a "matching effect" to insulate shareholders from increases in short-term rates; when short-term borrowing costs increase for Annaly as a result of higher short-term interest rates, the company is diversifying into the debt of commercial real estate properties (instead of just collateralized debt obligations guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac) so that it can achieve higher returns on its long-term investments to maintain something resembling a status quo spread.

When thinking about Annaly, I like to analyze this mortgage REIT based on the total income it will generate for shareholders over the course of a full business cycle. Over the past ten years, Annaly has delivered $19.04 in total income for every $16 share purchased. In other words, if you are patient long enough, you eventually get over 100% of your total investment back in the form of "dividend rebates" that allow you to play with house money after the passage of a decade.

The catch, though, is that the returns do not come in anything resembling a linear fashion: you know how Otto Van Bismarck once quipped that when it comes to good legislation and good sausage, no one should inquire into how it gets made? That's the spirit in which you should approach mortgage REIT investing: the total income is sporadic in that shareholders had to experience dividend cuts from $1.98 in 2004 to $0.57 per share by 2006, and have had to endure a recent slide that has taken the per share dividend income from $2.65 in 2010 to $1.20 per share today, although the total income generated by the initial investment remained impressive over the full course of the business cycle.

I used 2004 as an example year for a reason. That's the last time before the financial crisis in which investors were able to purchase shares of Annaly with a yield in the 10% range. It worked out quite well for shareholders that can handle volatility in dividend income, as every $1 invested produced $1.18 in dividend income over that time period. But here is what makes things extra compelling: shareholders in 2004 had to pay a 48% premium to book value, so that short-term rates had to fall (which they did) in order for Annaly to be a good investment. Today, the terms are much better: you are getting a slight 3-5% discount to book value, so that the low valuation already comes with built-in protection for rate increases and you can plausibly achieve $1.18 in total income over the next decade on every dollar invested if Annaly continues to follow its current script.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.