Income Investors: Positives Outweigh The Risks For Annaly Capital Management

| About: Annaly Capital (NLY)

With ten year treasury yields just barely above 2%, and bonds in general having paltry yields, income oriented investors must look elsewhere for income. Historically, real estate investment trusts (REITs) have among the highest yields of any stock group. The largest such company is Annaly Capital Management, Inc. (NYSE:NLY), and I will take a closer look at that stock, its business model, and how its metrics compare to competing companies in order to see whether an investment in NLY makes sense for income seeking investors.

NLY has been trading recently at a little under $16 per share. Its narrow 52 week range is from $18.79 to 14.05. As is common with REIT stocks, it has a very low Beta of 0.27. NLY has a market capitalization of a little over $15 billion, and a P/E of 11.5. Its generous annual yield is $2.40, for a current yield rate of 15%.

NLY is the nation’s largest mortgage based REIT (mREIT). Its fundamental business involves “playing” interest rate spreads, taking advantage of the low cost of funding versus the relatively high interest rate of mortgages. This situation was heightened by the Federal Reserve announcing in August a commitment to keep short term interest rates very low (between 0% and 0.25%) out until at least mid 2013.

A good place to start is a brief comparison of simple investing parameters of NLY, compared with a few other fairly well regarded REITs; HPC, Inc. (NYSE:HCP), Hospitality Properties Trust (NYSE:HPT) and Mack-Cali Realty Corporation (NYSE:CLI).


Market Cap (Billions)

Div. Rate

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What jumps out at us, obviously, is that NLY pays a stunning dividend, in dollar and percentage amounts, but still trades at a discount according to the P/E. And, when looking at NLY as an investment, it makes far more sense to look at the dividend stream source, than to divine future movements in stock price based on business fundamentals.

NLY reported a mixed bag of features in the third quarter of 2011. Under Generally Accepted Accounting Principles, NLY lost about $922 million. However, all of that loss and more was due to unrealized losses on interest rate swaps and interest-only mortgage backed securities. In excluding these non cash charges from calculated earnings, the total was a positive $623 million, or $0.65 per share. It is based upon that non GAAP calculation that NLY based its dividend payment.

NLY’s core business is focused nearly exclusively on residential mortgages, over 90% of which are secured by Fannie Mae, Freddy Mac, or Ginny Mae federal agencies. Therefore, credit issues have never been as much an issue for NLY as it has been for many other REITs.

NLY has, since its initial sale of stock in 1997, paid out over 90% of its earnings to shareholders in dividends, in accordance with applicable regulations on REITs, without reserving any retained earnings. Since 1997, some $7 billion has been disbursed to shareholders. NLY is aggressively taking advantage of the current interest rate environment by increasing its capital base by issuing stock, and purchasing ever more real estate.

The biggest near term risk to NLY is prepayment of NLY’s higher interest rate holdings. The U.S. Treasury exacerbated that trend by initiating what is known as a “twist.” The result is a flattening of interest rate curves, whereas a steep curve is the lifeblood of NLY. The current twist process has lowered NLY’s earnings and dividends by a dime or more a share each quarter of this year, and explains why the dividend payout has been trending down in recent quarters.

The share price itself, which I certainly view as a secondary concern, has also been trending down, and is not far from its 52 week low. The best explanation for this is a recent SEC edict that it would be reviewing all REITs to ensure they are in compliance with regulation.

Another risk is that the company has embarked on a planned sale of 300 million additional shares by 2012. It issued 138 million new shares in the third quarter, and reaped $2.4 billion in cash for corporate use. Not only may that be somewhat dilutive, but it will make the payment of the traditionally generous dividend that much more difficult to maintain.

In addition to its principal mortgage business, NLY operates a relatively small money management operation, with roughly $12 billion under management.

There is no guarantee that, given a long term flattening of yield curves, that NLY’s current earnings can be sustained. (Or Chimera's (NYSE:CIM) for that matter). In fact, many analysts are looking for earnings to retreat 10% to 15% over the next two years. But even there, with a dividend still well over $2.00 per share, the dividend yield would still be in double digits. Unless or until dramatic changes are made in the United States mortgage market, NLY has demonstrated it can bring tremendous dollar returns. One other positive about NLY is the relative consistency of its returns and dividends over the years. Through the boom years from 1997 to 2004, and the bust years of 2007-2009, one would scarcely know by looking at earnings charts anything had happened. If one is interested in buying shares in NLY, look first to a recent annual or quarterly report to read the letters from the chairman.

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