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Annaly Capital Management (NYSE:NLY) is the largest mortgage REIT listed on the NYSE. With a market capitalization of over $15.5 billion, the company dwarfs almost all others in the sector. In line with REIT legislation, the company pays out 90% of its REIT earnings by way of dividend, and since coming to the market in 1997 has paid out over $7 billion in dividends to shareholders.

NLY shares are currently trading around $16.25, and the mean 12 month price target from analysts researching the stock is $17.53 (8% upside potential). This stock is trading below its 50-day exponential moving average of $17.76, and its 200-day exponential moving average of $17.71. The move below these averages first happened in mid September, as news that the SEC is considering tighter regulation, in line with other investment companies, reached the market. Since then the share price has recovered from the immediate aftermath of the announcement though has proved reasonably volatile.

Earnings per share for the 12 months to end December 2011 are expected to be $2.51, though expected to fall over the following 12 months to $2.30. The shares trade on a trailing price to earnings ratio of 11.87, and a forward multiple of 7.02. The trailing ratio compares to the industry average of 12.64, and the forward multiple is comparable to those of competitors Capstead Mortgage Corp (NYSE:CMO) and Redwood Trust (NYSE:RWT), at 7.85 and 9.61, respectively.

For investors looking at dividend paying stocks, NLY’s payment of a dividend of $2.40 last year gives the stock a yield of 14.90%.

Current operating margin at NLY is 84%, compared to CMO’s 90.40%, and RWT’s 56%. Return on Equity at NLY is 8.70%, and at CMO it is 13.39%. RWT’s return on equity is a more modest 4.30%.

The company has $4.89 billion in cash, and debts of 90.50 billion, and suffers a Debt/ Equity ratio of 567.63. This size ratio is determined by the REIT business model: RWT’s is 897, and CMO’s is 475.

Shareholders have seen the value of their holding decline by around 8.5% over the last 12 months, and under-performed the S&P 500 Index. For me, the trading pattern over the last couple of months is reminiscent of early to mid 2008. Share price declines back then were dictated by the financial crisis, and in particular the problems of mortgage backed debt. The initial downturn this time around has been caused by the SEC announcement as previously discussed.

However, with the global economy slowing, and property prices struggling, still, to recover, there will be question marks over REIT company’s ability to reach forecast numbers over the next couple of years.

The dips seen in NLY’s share price at the beginning of September, though prompted by the SEC announcement, may be part of a bigger, developing picture.

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Perhaps a way to look at the valuation of NLY is to look at potential future dividends and compare them to today yields. Should the company pay out 90% of its expected earnings of $2.30 in 2012, then the dividend would fall to $2.07. If the yield were to remain at 14.90%, then this would indicate a potential downside to the share price of $13.89.

Overall, the trading pattern of NLY shares, and the backdrop of a weakening economy, along with declining job prospects and a fall in disposable incomes, do not paint a strong case for holding NLY shares at this time. Add in to this mix the uncertainty of any SEC decision, and worsening debts in the personal and governmental sectors, and it becomes even more difficult to do so. At this moment in time I think that there is more downside risk in the shares than upside potential, and would not be a holder myself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Annaly Capital Management: More Downside Risk Than Upside Potential