In an earlier controversial article here, I argued that Annaly Capital (NLY) and Chimera (CIM), related firms, were just too good to be true. Since then, there has been underperformance to the Dow Jones, missed expectations, and lowered dividend yields. The stock of Annaly and Chimera are down 1.2% and 6.4%, respectively, while the Dow Jones rose by 2.2%. At a time of macro uncertainty and housing troubles, REITs, in my view, are not the way to go.
From a multiples perspective, Chimera is the cheaper of the two. It trades at a respective 5.1x and 5.7x past and forward earnings while Annaly trades at a respective 8.4x and 7x past and forward earnings. Chimera also offers a dividend yield of 16.7% - around 250 bps higher than Annaly.
At the third-quarter earnings call, Chimera's CEO, Matthew Lambiase, nevertheless noted how the company could take advantage of the current business environment:
[A]s you know the financial markets continue to be turbulent and the recent news of sovereign debt deals in Europe’s welcome but probably not sufficient to calm the markets of the doubts of capital adequacy of its European banks. European banks may be forced to raise large amounts of capital and require to sell assets in the near future. In our opinion it’s most likely that they will see non-core, non-European assets like U.S. dollar denominated mortgage backed securities, CMBS or corporate bonds. When this happens, there may be a significant opportunity for those companies that have the ability like Chimera and the liquidity to take advantage of the selling…
Second, there has been a major change in the jumbo prime lending landscape. On October 1, Fannie Mae and Freddie Mac reduced the conforming loan balance and now $625,000 is the largest amount that they will guarantee. In the past few years, it’s been very difficult for private capital to compete with the efficiencies of the U.S. agencies, and now lowering the conforming loan balance should create opportunities for companies like Chimera who wish to purchase and securitize new jumbo prime mortgages.
It is noteworthy, however, that management - just, like that of Annaly - spent basically no time discussing the actual results. While both firms have a past record of success, it is still unclear whether this is actually a license to be excused from best practices during earnings calls. As it turns out, third-quarter earnings were down by more than a half sequentially. In addition, the fourth-quarter dividend was reduced by 15.4% to $0.11, payable on January 26.
Consensus estimates for Chimera's EPS are that it will decline by 28.8% to $0.47 in 2011 and then by 4.3% and 4.4% more in the following two years. Assuming that the multiple more than doubles to 8x and a conservative 2012 EPS of $0.41, the rough intrinsic value of the stock is $3.28, implying 24.2% upside. If the multiple were to decline to 5.5x and 2012 EPS turns out to be 13.3% below the consensus, the stock would fall by 18.6%. I agree with the consensus rating of "hold."
The main problem that I have with Annaly is the dogged trust in management. While management is truly stellar, I tend to agree with Cramer's skepticism about the experts-are-always-right mentality (or hope). In any event, Annaly had to cut its fourth quarter dividend by 5%. Part of the issue stems from quicker MBS prepayments, LIBOR rise, and increased repo borrowing rates. Investors have reason to be concerned about MBS yield and shrinking net interest spread. In this feared environment, bond yields may rise and consequentially reduce book value. Opportunities include interest shifting to agency MREITs and Fannie Mae (FNMA.OB), not surprisingly, eliminating the requirement for documentation of a borrowers' reasonable ability to repay.
Consensus estimates for Annaly's EPS are that it will grow by 3.4% to $2.41 in 2011, decline by 5% in 2012, and then grow by 1.3% in 2013. Assuming a multiple of 8x and a conservative 2012 EPS of $2.18, the stock has 8.6% upside. If the multiple declines to 6x and 2012 EPS turns out to be 9.6% below the consensus, the stock would fall by 22.7%. Note that the company pays out earnings from dividends and this form of valuation does not provide the clearest target, but some general picture. Note also that analysts rate the company a "buy."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.