Bears Roar 'Sell' For Risky Chimera, Annaly

Includes: CIM, NLY
by: Takeover Analyst

Chimera Investment (NYSE:CIM) and Annaly Capital (NYSE:NLY) both are rated poorly on the Street. While the former is rated near the "sell" end, the latter is rated closer to a "hold." Based on my review of the fundamentals and macro outlook, I find that both firms have significant risks and the Street's reservations are warranted.

From a multiples perspective, Chimera is the cheaper of the two. It trades at a respective 5.6x and 6.5x past and forward earnings with a dividend yield of 15.1%. Annaly, on the other hand, trades at a respective 33.6x and 7.7x past and forward earnings with a dividend yield of 13.8%.

At the fourth quarter earnings call, Annaly's management continued to address actual performance and instead opted for story telling:

The title of the missive today is called Paradise Lost. There was a time when the market was the market, a large collection of free thinking participants who independently evaluated cash flows, earnings, and economic data among many other things in an effort to establish value. A time when skilled and ambitious managers could successfully outperform their less diligent competition through creative interpretation of all that was happening around them. A time when very few people outside of the burn market knew the name of the Chairman of the Federal Reserve. A time when an excentric group of practitioners called Fed watchers would figure out the price of short term money by closely observing the supply and demand of each day. A time when burn market participants would determine long term rate based on levels of debt, credit worthiness of the borrower and inflation expectations. A time when recessions were painful, yet natural part of the business cycle, a call for businesses to evolve or die or for companies and employees to retool, re-educate and re-evaluate the inputs of success.

Part of the reason why the company is rated a "hold" is because the Street is unsure how congruous the management's confidence is with the fundamentals. We are told to put substantial faith in the team's deep-industry knowledge, but are ultimately left with vague pointers for the future.

As it turned out, EPS of $0.54 was 5.3% below consensus as the portfolio contract by 2% sequentially. Spreads further compressed a staggering 22% sequentially to $0.42/share while leverage fell. The marginal decline in book value has further given analysts pause.

Consensus estimates for Annaly's EPS forecast that it will decline by 24.1% to $1.95 in 2012, grow by 7.2% in 2013, and then decline by 6.7% in 2014. Assuming a multiple of 8x and a conservative 2013 EPS of $2.06, the rough intrinsic value of the stock is $16.48, implying that it will hold roughly flat.

Chimera is dependent on strong pricing trends for non-agency residential mortgages and the re-securitization markets. But secular trends are under significant pressures from a tough regulatory environment and less risky debt bundling. The firm's portfolio has declined by roughly one-fifth from 2010 to $4.4B in September 30. Interest income from the portfolio is expected to decline as re-REMICs deleverage. The dividend has continued to fall from 4Q10. With that said, cash flows strengthened in November from greater principal payments.

Consensus estimates for Chimera's EPS forecast that it will decline by 28.8% to $0.47 in FY2011 and then by 4.3% and 2.2% more in the following two years. Assuming a multiple of 8x and a conservative 2013 EPS of $0.43, the rough intrinsic value of the stock is $3.44, implying 17.8% upside.

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