Annaly: Boom Goes The Dynamite

| About: Annaly Capital (NLY)

Summary

Annaly is acquiring Hatteras.

I discuss the deal and the impact to Annaly's operations.

I will be watching one key metric after the deal closes.

As you know, I have covered Annaly Capital (NYSE:NLY) many times over my writing career. Last year, I specifically discussed how the company's history of dividends and its insider buying impacted you. I also covered its recent financial wizardry which I felt the company was employing to mask potential weakness. That said, the name has been incredibly stable over the last two years price wise while yielding a solid 11-12%. Rather than rehash key background information that can be found in a multitude of my prior pieces, let me simply say that provided the company is covering its dividend, this type of share price stability is welcomed. Everyone would love share appreciation too, but it is great to see the stock's bloodletting cease. That said, the last two years have really seen some changes. Annaly has made some big moves, including diversification into non-agency securities and making some adjustments to its hedging approach. This morning the company made another strong move. It has announced it will acquire Hatteras Financial (NYSE:HTS). Boom goes the dynamite as they say.

Now look I won't sugar coat this. I am on record of having substantial concerns over Hatteras' ability to pay its dividends. The sector continued to deteriorate and the company recently cut the payout once again, down to $0.45. In Q3 2014, it lost registered a loss of $84.9 million. In Q4, things improved to positive $0.08. I will discuss the reasons for this move. In Q4, core earnings were $0.45. This was flat quarter over quarter and is down from $0.50 in Q2 and down from the $0.56 per share in Q1. Of course, this just barely covers the dividend of $0.45. As such, we have to be concerned with the dividend. Further book value bleeding continued in Q4, with book value dropping to $19.38. Shares were at over a 30% discount-to-book the last few months.

So why is Annaly scooping up the company and what are the terms? Well, Annaly will acquire Hatteras for consideration to be paid in cash and shares of Annaly common stock, which valued Hatteras at $15.85 per share, a 24% premium to the 60-day volume-weighted average price. Now, more specifically, Hatteras' shareholders can choose to receive $5.55 in cash and 0.9894 shares of Annaly common stock or $15.85 in cash or finally, they can receive 1.5226 shares Annaly for each share they own.

So what will this do for Annaly? What is it getting out of it? Well, first let's remember that Hatteras has a portfolio that was very synergistic with Annaly's. Hatteras owns residential mortgage backed securities, mortgage servicing rights as well as residential whole loans. Further, it ups the company's capital base, allowing it to sell off assets it does not see as beneficial and can redeploy it as it sees fit. In addition, management sees the transaction as accretive to Annaly's book value and core earnings in 2016. This could translate to higher dividends should the company deliver. Kevin Keyes, CEO and President of Annaly stated:

"This strategic transaction represents a unique and sizeable value creation opportunity for our shareholders. With the acquisition of Hatteras, we significantly grow our diversified portfolio and broaden our investment options, further fortifying Annaly's position as the market leading mortgage REIT."

Further, Wellington Denahan, Chairman of Annaly, added:

"We are tremendously excited to announce this partnership today. Both Hatteras and Annaly are seasoned veterans in the sector, and we are confident this acquisition strengthens our ability to deliver superior returns to our shareholders over the long term."

On the Hatteras side of the equation, a 24% premium is a strong return. Shareholders also have the choice of how they wish to participate. The deal is scheduled to close in the third quarter of 2016. I see it as a positive for Annaly. It is getting a great price on the assets. The one key metric I will be watching for in the subsequent quarters following this transaction is the constant prepayment rate. Simply put, the lower this is the better, as it pads interest income (or rather prepayments hurt interest income). It is now the most critical indicator to watch, as it impacts all others. As you know, a higher constant pre-payment rate hurts, and this metric has absolutely crushed the sector. Why am I mentioning this? Well, because Hatteras was plagued by a high constant prepayment rate. I think this could hurt Annaly's constant prepayment rate if it holds onto a lot of the assets. This is because in Q3, the constant prepayment rate of Hatteras reached crisis levels. It came in at 21.1%. In Q4, the constant prepayment rate did decline to 17.2%, which is well above the sector average.

The bottom line here is that things continue to steadily move along for Annaly, and you are being paid a hefty dividend for sideways action in the stock. This action sets up interesting potential to make profit by trading around a core position. We need sustained results, but to see them, we need a turn in the economy and favorable rate conditions, along with effective management. I think this acquisition is a bold move, and I am looking forward to seeing the impact to the core earnings of Annaly.

Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "Follow." He also writes a lot of "breaking" articles, which are time-sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."

Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles that are time sensitive. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."

Disclosure: I am/we are long NLY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.