Annaly Moves Smartly To Lower Hedge Positions, Thereby Increasing Core EPS

| About: Annaly Capital (NLY)


Increase in core EPS will improve company's dividend coverage.

Annaly’s diversification to commercial and triple net lease assets reduced dependency on traditional agency MBS.

Stock an attractive total return opportunity of 17.30%.

Annaly Capital Management, Inc (NYSE:NLY) is an internally managed mortgage REIT company, which primarily invests in agency RMBS on a leveraged basis. The company has also invested in commercial MBS to diversify its asset base. I continue to remain bullish on the company because the management has rightly given up its defensive approach and reduced its hedged position to boost its core EPS. I also raise my price target to $12.6 due to the significant improvement in book value in the last quarter. Furthermore, NLY's diversified portfolio paints a compelling outlook for future growth.

Strategic Initiatives
In my previous article on the company, I predicted the increase in core EPS in the second quarter because of the expected reduction in hedged positions and diversified portfolio. The company has cut down short-dated swap positions of $24 billion, which were initially raised to manage the rise in short-term interest rates. Overall, the swap portfolio decreased to 40% of repo in the second quarter as compared to 96% of repo in the first quarter of the year. In the earnings call, the management indicated that they have to take the risk somewhere and I believe they have opted for the right strategy. The cost of funds reduced by 37 bps QoQ, which in turn increased the net interest spread by 36bps. This, I believe, was the primary reason behind the earnings beat in the second quarter.

The Fed has made it clear that it will continue its expansionary monetary policy, as slacks continue to exist in the labor market. The two slacks identified by the Fed are low wage growth and labor force participation rate.

I believe the company has done the right thing by lowering hedges because short-term rates are expected to remain low. In last month's job report, the labor force participation rate improved by only 10bps. On the other hand, hourly earnings experienced a modest increase of $0.01. So, these measures are significantly lower than the Fed's target, which shows that interest rates will remain low. What the management needs to do is closely follow the labor market and adjust its hedged portfolio accordingly.

The management also thinks that the market is strong enough to stand the rise in short-term rates and the end of the Fed's stimulus package. Wellington Denahan, the CEO of NLY, said on the earnings call:

"The fundamentals of the mortgage market remain strong, notwithstanding the reduction in asset purchases by the Federal Reserve, and we'll continue to offer competitive relative returns even as short rates move higher."

I completely agree with the management's first point. The end of the asset purchase will not have a significant impact on the company, and the transition will be smooth due to favorable demand-supply dynamics. The Fed still continues to be the major player in the market, as supply is expected to remain low. However, a rise in short-term rates will threaten the company's book value and EPS.

The company is also looking to diversify its portfolio. In the first quarter, the management indicated that it is expected to increase its capital allocation of commercial MBS to 25% from 12%. However, in the second quarter, the allocation remains flat around 12%. The management reiterated its guidance, but said there was no timeframe. It means that the company is looking to expand its commercial portfolio when they see attractive opportunities in the segment. The commercial portfolio helps to diversify its asset base and also offers a higher yield than traditional agency MBS. NLY is also looking to invest in triple net lease assets to further diversify its asset base.

A well-diversified asset base is good for the company because it reduces its dependency on traditional agency MBS. NLY continues to operate with the lower leverage (debt-to-equity) of 5.2x, which means that the company could increase its leverage to benefit from attractive opportunities.

Dividends and Valuations
The company's core EPS increased to $0.30 per share in the second quarter, which covers its quarterly dividends. I expect the strong growth in core EPS to continue due to the management's aggressive approach in the low interest rate scenario. Also, investments in commercial and triple net lease assets continue to enhance the risk return profile. Currently, NLY offers an attractive and sustainable yield of 10.30%.

In the second quarter, the book value increase by 7.6% to $13.23 per share. This performance was primarily attributed to the tightening of the spread of agency MBS. Currently, the company is trading at a price-to-book value of 0.88x and a price of $11.76 per share. I am raising my price target to $12.6 due to the strong increase in book value. My price target is based on 0.95*BVPS, which means price appreciation of 7%.

The company has rightly reduced its hedged positions to benefit from low interest rate scenario. This has helped NLY increase its core EPS, which in turn improves the dividend coverage of the company. Furthermore, NLY's diversification to commercial and triple net lease assets also reduced its dependency on traditional agency MBS. Also, it continues to offer an attractive total return opportunity of 17.30%.

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.