Annaly Capital Management (NYSE:NLY) announced the acquisition of Hatteras Financial Corp. (NYSE:HTS) on Monday morning and shares of both companies opened at materially different levels. For Hatteras Financial Corp., the gain in share price remained throughout the day as shares traded at a fairly flat level. The math to find the new value on shares of Hatteras Financial Corp. is quicker than the math to determine the impact for Annaly Capital Management. It appears to me that shares of Hatteras Financial Corp. are already reflecting a 100% chance of this merger going through. The implications for Annaly Capital Management are substantially more interesting.
This little section is added after the rest of the analysis was prepared. The goal is to address the changes in price and the impact those changes will have on the investment thesis.
NLY opened weak on the news, but moved up to close about even on Monday. Since then, they traded down less than 1%. I consider that movement immaterial. HTS soared on the announcement and the very clear math on what shareholders of HTS would receive combined with a larger market capitalization (that leads to more coverage) allowed shares of HTS to open almost precisely at their fair value with the transaction. Since shortly after the market opened on Monday there has been almost no movement in shares of HTS.
The rest of this analysis is primarily focused on demonstrating the steps I went through to analyze the deal.
Assets of HTS
The following image shows the breakdown across the broad asset categories:
Since Annaly Capital Management is holding non-agency assets now, there is no huge problem with absorbing this portfolio. It will be interesting to see if they sell off the MSR portfolio, though. MSRs have been problematic for most mREITs over the last few years. A few have pulled it off, but American Capital Mortgage Investment (NASDAQ:MTGE) demonstrated the problems clearly prior to their decision to change their strategy.
Options for HTS Holders
The following table demonstrates the 3 options that will be available for shareholders of HTS:
The three options available to shareholders were not equal this morning because shares of NLY opened weak. By the end of trading, shares reached $10.44 and the result was very similar total values regardless of which option the shareholder of HTS picks.
Price and Value
The following charts will simply use the Q4 ending book values. Annaly Capital Management intends to structure this transaction so that approximately 35% of compensation will be in c ash and 65% will be in stock. Since we know rough values on each side, I can quickly assess how much NLY is paying:
The following table quickly finds the value of all common equity of HTS:
Seeing that NLY is paying around $1.658 billion for book value of about $1.865 billion makes it clear this deal should be positive for NLY.
NLY will also be acquiring the preferred equity of HTS which currently trades around $24. The price on the preferred shares is less than the liquidation which suggests that having the preferred shares outstanding is another positive factor.
Impacts of the Transaction
The next chart shows Annaly Capital Management's total equity and the changes that are anticipated as a result of the transaction:
I expect this deal to increase book value for NLY by about $0.20 per share excluding any merger-related transaction costs. The net result should clearly be accretive for Annaly Capital Management and it brought immediate upside to holders of Hatteras Financial Corp.
Caution on Book Value
By my calculations for the MBS prices and the impact of hedges, I believe Annaly Capital Management's book value at the end of Q1 in 2016 was lower than their book value at the end of Q4 2016. I would expect the losses during the first quarter to reduce book value by something in the ballpark of $0.15 to $0.25, so this deal effectively mitigates the loss of book value that would be anticipated.
The increase in book value is giving NLY more equity to leverage which strengthens the sustainability of their dividend.
I see this as an excellent transaction from both sides. The price gain for HTS was huge as the deal dramatically reduced the discount to trailing book values, but it offers long-term benefits to Annaly Capital Management. This deal is also positive for the industry because it suggests that even a company with book value of over $1.8 billion can still be acquired. This puts almost every mREIT in the sector into play and reinforces the importance of finding mREITs trading at substantial discounts to current book value (rather than just trailing book value) and assessing management's willingness and ability to agree to a buyout that creates gains for both sides.
The interesting aspect of this deal is that it is effectively valuing HTS at a mere 81.7% of trailing book value. Over the last few weeks, I've cautioned investors not to put too much faith in the idea that book value is the fair price for an mREIT. With four buyouts complete, the compensation offered to shareholders is generally ranging from about 80% to 90% of either trailing or current book value. If management agrees to sell the mREIT at that discount, it reinforces the idea that book value is not the inherently correct price for an mREIT.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in THE PREFERRED SHARES OF HTS OR ANY SECURITY OF MTGE over the next 72 hours.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.