Annaly Capital: A Great Buy For Strong Income In 2012

Dec.22.11 | About: Annaly Capital (NLY)

Annaly Capital Management (NLY) is a real estate investment trust that invests primarily in agency-backed mortgage securities. The business model is based on the ownership and financing of a portfolio that invests in mortgage-backed securities. In its most simple form, Annaly borrows short-term funds that invest in long-term securities. The spread between the short-term interest rates and the long-term interest rates creates the backbone of Annaly's business model. Using an appropriate leverage level Annaly exploits this difference to boost its profits. As stated in the company's business strategy

Our net cash flows result primarily from the difference between the interest income on our investment securities and borrowing costs of our repurchase agreements and from dividends we receive from our subsidiaries.

One of the best parts of Annaly is its corporate tax-free status. As long as the company distributes at least 90% of its taxable income, it is not subject to federal corporate income tax. Dividends are taxed according to individual circumstances.

Recently, one of the readers claimed that higher interest rates will destroy Annaly's balance sheet. It is true that higher interest rates will lower the value of existing bonds. However, FED's operation twist is aimed at reducing the long-term interest rates -- not raising them. As I stated here, operation twist will have two policy actions:

1. Fed will buy long-term bonds, shifting the demand curve for the long-term bonds upward. If the demand for long-term bonds gets higher, the price of the long-term bonds will also get higher, driving down the long-term interests.

2. Fed will sell short-term securities, shifting the demand curve for the short-term securities downward. If the demand for short-term securities gets lower, the price of these securities will also get lower,driving up the short-term interest rates.

Thus, in the short-term operation twist might even benefit Annaly’s balance sheet by increasing the value of long-term bonds in the portfolio. Recently, Annaly announced a 4th quarter dividend of $0.57 per share, payable January 26, 2012 to shareholders of record on December 29, 2011. This dividend is 3 cents lower than the last dividend, but I do not think there is any need to panic. The trailing EPS and forward EPS estimate gives a sustainable dividend range of $1.92 and $2.30, which translates into a yield range of 11% - 14%. That is one safe dividend in a risky market. I think, as long as the company offers a double-digit yield, Annaly offers a good deal.
My safety criteria for Annaly is a minimum of 10% yield with a maximum trailing P/E ratio of 10. Based on 3% EPS growth estimate, my fair-value range for NLY is $24 - $40. Its O-Metrix score of 10.8 is also well-above average. It is not easy to find a double-digit yield backed by the federal government agencies. Therefore, I rate Annaly as a great buy for strong income in 2012.

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