Annaly Capital Management (NYSE:NLY) is a mortgage REIT with a long operating history. Investors in any mREIT should look to NLY as setting the bar for the industry, and other mREITs can be measured based on how they are performing relative to Annaly Capital Management. Despite the long history of operations, investors in NLY may still think of the company as a black box that simply creates dividends. My goal as an analyst is to make it as simple as possible for investors to understand the operations. Of course, it is also my goal to identify excellent investment opportunities for making money.
Making Complex Things Simple
Many investors think mREITs are complex, and I fear the mREIT industry rarely tries to dispel that myth. Due to the way fair values and historical amortized costs interact, it easily possible for investors to wonder what is happening inside that black box of dividends.
Over the last week or two, I've been digging into several other mREITs that have neither the size nor the clarity that NLY provides. The experience reminded me of the importance of going through complex statements and making them simple. When an mREIT underperforms and investors have no idea why the company just keeps failing, it would be useful to have some tools designed for rapid analysis that could identify the weak spots.
That brings me to the tool I created for "rapid" analysis. While reading it is fairly rapid, the process of building it and adding new mREITs is far from rapid. The objective is to simplify assessing which mREITs are inherently challenged and which ones are not. This should allow investors to rapidly recognize when some mREITs simply are not worth book value, and to assess what relative discounts could be justified. It also gives investors an idea of whether a company's portfolio might perform dramatically better if purchased by a competitor.
The following chart represents one piece of the output from the tool:
With this chart, I've used the data for each fiscal year to establish the total value for each category and then divided them by the basic weighted average shares outstanding. The resulting value is then divided by the book value per share from the start of the year. Since these values can change quite a bit during the year, the calculations won't be quite perfect. However, I believe this provides the best quick estimation possible in many cases.
Reading The Chart
The green and pink cells identify the areas that I want to highlight for discussion. The presence of several cells with 0% in them indicates that the tool was designed to accommodate more complex portfolio compositions.
I'm concerned about the performance of the mREITs when the yield curve flattens. Specifically, long-term rates falling and dragging down the rates offered on new mortgages is a substantial problem for mREITs investing primarily in agency RMBS. The problem is demonstrated here using the top green bar. The interest income as a percentage of the starting book value for 2015 was fairly weak at 17.5%.
The next green bars highlight the interest expenses, which investors can easily see are declining significantly year over year. The interest expense indicated as being paid on swaps also declined as a percentage of starting book value. That suggests we are also looking at the impact of a lower amount of average leverage. However, the decrease in net swap expense is also fairly substantial.
The third green area is the net interest income that would remain if investors treat preferred dividends as a form of interest expense. For the preferred shareholder, it would be inaccurate to assume that their preferred dividend takes precedence over management paying themselves. Management of every mREIT always gets paid first - never forget that. The way these lines are organized is designed to provide a better picture of net interest income from the perspective of the common shareholder, which has no claim to either the money paid to management or to preferred shareholders.
NII to Management and Common Combined
The level of NII showing up in this bar appears to be the highest of the last 3 years, and that could easily make investors believe that everything is great for mREITs. That would be a foolhardy conclusion that could be the prelude to losing capital by scoffing at risk.
The next green bar brings us to the amount that operating expenses are taking out of net interest income. I'm specifically excluding any administrative costs that are consolidated into the statements from investing in first loss tranches, because I incorporate those costs at a higher level, since I think it provides a much more accurate picture. The ratio of administrative costs here represents a drag on the return on equity investors can achieve. These costs are a drag regardless of the metrics the investor is using. Investors could use GAAP EPS for ROE (this would be a little stupid), Core ROE, Comprehensive income ROE, or Total Economic Return, and the cost would still represent a similar drag across each format.
NII to Common
The next bar indicates the amount of NII that is theoretically available for common shareholders. This will usually be roughly similar to Core EPS if management of an mREIT is not boosting the metric. However, both Core EPS and this metric could be enhanced by heavy use of futures contracts or forward starting swaps. Neither of those is a huge source of hedging for Annaly Capital Management, though small amounts of both may be used.
The following chart demonstrates the level per share that would be reported under my method for the last four years:
The value over the last 3 years is averaging within a penny of $1.20. The quarterly dividend is $.30, so the annual level of the dividend matches almost perfectly with the level of NII to common shareholders. That is a positive sign for shareholders.
As a quick reminder, drop income has been added into these figures, and the drop income for 2015 was an important factor in hitting this level. I don't love using drop income as a source of dividends, but it seems reasonable to count it, since it is essentially the interest income that would've been expected if the MBS were on the balance sheet.
NII to Common Net Impairments
This line exists solely to check whether the company is regularly creating impairments that may be classified as "one-time" events. If every year includes material losses on one-time events, it would cease to be reasonable to assess the company as if they were not recurring.
Realized Loss on Termination of Swaps
The pink square here highlights the amount of realized loss on the termination of swaps. I wanted to highlight this for 2014, because it was fairly significant. The decision to cut a substantial portion of hedges would appear to be the most likely reason for the sudden decrease in the net swap expense. Since the decrease in the net swap expense was critical for the increase in the level of "NII to Management and Common Combined," investors should be skeptical about the decrease. It would appear one significant part of the improvement was tied to ending swaps with higher rates that were in positions of "unrealized loss."
The challenge for mREITs investing currently and investors buying into Core EPS is that reduction in the swap expense as a result of restructuring swaps. If MBS rates move higher, it wouldn't create a sudden increase in asset yields unless an mREIT turned over a material portion of its portfolio (at a realized loss) to buy new MBS at higher yields. I don't expect Annaly Capital Management to play that game, but I'm not convinced that every mREIT will avoid that strategy. If Annaly Capital Management is too ethical to engage in gaming the numbers that way, then investors should expect asset yields to continue suffering as the mREIT receives prepayments on existing MBS and reinvests the proceeds at a lower average yield. If management of a mortgage REIT decides to play that game, it would give investors cause for concern. Unfortunately, I think most investors and many analysts wouldn't notice what was happening.
In quarters where rates move materially higher, there would be adjustments to amortization expenses that would create the appearance of asset yields jumping materially higher. By using annual numbers the impact should be reduced, but it can still be significant.
I would be neutral at share prices around $9.50-9.65. I would be bullish at prices around $9.10. If shares of NLY sell off to that point, there will probably be some smaller mREITs selling off to absurd levels and providing excellent investment opportunities. The idea that a mortgage REIT should trade within 5-10% of book value is strongly contradicted by four mREITs agreeing to buyouts ranging from 80% to 89% of trailing book value.
For the "buy and hold" investor, I believe it is prudent to remain patient and wait for better prices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.