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Summary

  • The company’s core EPS experienced a massive decline, pressuring dividends.
  • NLY has decided to reduce short dated swap position by $24 billion.
  • Tapering will not remain such a big concern if economic indicators continue their solid trends.

Annaly Capital Management, Inc. (NYSE:NLY) is an internally-managed mortgage REIT company which primarily invests in agency residential mortgage-backed securities. However, the company is now focusing to diversify its portfolio by increasing its exposure to commercial properties. It is also adding triple net lease assets in its arsenal. Furthermore, NLY continues to offer an attractive double-digit dividend yield of 10.30%. Although the yield does not look sustainable, it is expected to improve as the company reduces its hedge position and increases its asset yield through its diversified portfolio. Lastly, the macro-economic environment is shaping up favorably to make interest rates more stable and predictable.

Macro-economic Environment
The recent U.S. jobs data for the month of June was thrilling. It was the sixth consecutive month in which the number of jobs added exceeded 200,000. In the last month, 288,000 new jobs were added, which has helped bring the unemployment rate to 6.1% from 6.3% in May. The jobless rate was the lowest in almost six years, while the labor force participation rate remains stable at 62.8%, which confirms that the labor market is showing an improvement. Another encouraging sign is that nearly all sectors have experienced job growth, which means growth is not concentrated in a limited number of segments.

Josh Feinman, an economist at Deutsche Asset and Wealth Management, is reported to have said, "It's a strong report; there is no question about it. The labor market is improving at a seemingly stronger rate than before, the slack is being absorbed, we are chipping away." There are some slacks, as people working part time and looking for full time jobs increased, which continues to remain a concern for the economy. Also, the number of working hours rose by 0.2% which means more work within the same income.

Market confidence was at its peak after the June data came out last Thursday, as both the Dow Jones and the S&P 500 closed at record highs. The job data has a few shortcomings, and inflation is not yet on the Fed's target, but the important thing is that while the economy is improving and moving in the right direction. These are the slack points that might cause the Fed to delay an increase in short-term rates. Overall, the economy is growing, markets are confident and movements in interest rates are predictable, thus painting an encouraging outlook for mortgage REITS, especially the well-diversified NLY.

Well-Diversified Portfolio is the right approach
The company's first quarter was below analysts' expectations, as it reported a core EPS of $0.23 per share, with a drop of approximately 35%. The primary reason behind the massive drop was the decline of 53bps in net interest margin. The yield on the portfolio fell because the positive impact of the lower prepayment rate from Q4 of the last year was normalized. The cost of funds was also high due to an increase in the hedging cost. However, I believe the pressure on net interest margin will decline in the rest of the year because of three reasons.

Firstly, NLY's management will reduce its $24 billion short-dated swap position, which was taken to tackle the rise in short term rates. Policymakers have now indicated that short term interest rates will remain low for a longer time period than had been anticipated previously.

Secondly, the company is looking to diversify its asset base to enhance its risk return profile. NLY is planning to expand its commercial residential portfolio and increase the allocation to 25% from 12% of capital allocation. The commercial investment portfolio yield is 9.18%, which is significantly higher than other MBS investments. Furthermore, it has also announced plans to acquire triple net lease assets with the help of Inland Real Estate Group of Companies. This acquisition will give the company access to various markets, including industrial, office, rental and restaurants. These markets are expected to perform better in improved economic conditions.

Although NLY increased its leverage in Q1'14 to 5.2x, it was still lower than its peers' average, which means the company has room to increase its leverage to target the above mentioned diversification and still continue to maintain its leverage at a manageable level.

Lastly, the prepayments rate is expected to decline in the second quarter, which will help support net interest margin at least in the second quarter of the year.

Dividends
It is often argued that dividends drive the stock price for REITs and I believe this is true. With a core EPS of $0.23 per share and dividends of $0.30 per share, NLY does not paint a compelling story for investors. But I believe that the diversification of its portfolio will help increase the company's asset yield, and in turn increase the core EPS. The company has maintained its quarterly dividends at $0.30 per share for the last three quarters, and I believe it is capable of sustaining its yield with the improved performance in the second quarter and thereafter.

NLY is trading at a significant discount to its price-to-book of 0.899x. I expect the gap to narrow down in the future because it has historically traded above its book value. Furthermore, NLY has significantly increased its exposure to commercial properties, and commercial mREITs trade at a premium to book value. So, I am also expecting price appreciation of 6.6%, based on my price target of $11.80.

Conclusion
The company's core EPS experienced a massive decline, which also pressurized its dividends. However, NLY has been taking the necessary steps by diversifying is portfolio, which is an encouraging sign for the prospects of its future growth. Also, it has decided to reduce its swap position by $24 billion. Lastly, I believe tapering will not remain such a big concern if economic indicators continue their solid trends.

Source: Diversified Portfolio Secures Annaly's Future Growth Prospects