Annaly Capital Management Can Make A Great Dividend Investment... If You Keep These 3 Things In Mind

| About: Annaly Capital (NLY)

Summary

Annaly Capital has had a great year, despite ongoing difficulties with its business model.

Shares are now historically overvalued, and the dividend is far from secure.

But Annaly remains a potentially excellent choice for long-term mREIT investors, especially with management ongoing diversification efforts.

Find out the 3 most important things investors need to keep in mind if they want to invest in this high-yield dividend stock.

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Source: Annaly Capital Management

Annaly Capital Management (NYSE:NLY), is the oldest and largest mREIT, and an old favorite among yield-starved dividend investors. However, since the end of the credit crisis, it has severely underperformed competitors such as American Capital Agency Corp. (NASDAQ:AGNC), Blackstone Mortgage Trust (NYSE:BXMT), as well as the S&P 500.

NLY Total Return Price Chart NLY Total Return Price data by YCharts

Find out the three most important things long-term dividend investors need to know about the future of Annaly in this time of extreme interest rate uncertainty. More importantly, find out whether or not it's still worth owning this mREIT today.

Yield curve flattening remains a threat to the dividend

Source: Annaly Capital Q1 2016 earnings presentation.

For years, investors thought that interest rates couldn't drop any lower. Yet, in today's crazy post-Brexit world, where even 50-year Swiss bonds are selling for negative yields, Annaly faces the prospect of ongoing spread compression.

Potentially more troubling is that some at the Federal Reserve, such as Atlanta Fed president Dennis Lockhart, continues to insist that stronger-than-expected US economic growth could still mean as many as two interest rate hikes this year. That could mean higher borrowing costs for Annaly.

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Annaly's respective Agency, and Residential mortgage portfolios

Source: Q1 2016 earnings presentation.

Since 73% of Annaly's capital is invested in fixed interest rate residential mortgages, Annaly might face ongoing core EPS erosion, that means further potential dividend cuts in late 2016 or 2017. That's especially true if mortgage rates don't rise fast enough to prevent further net interest income spread compression.

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Source: Annaly Capital Q1 2016 earnings presentation.

Management is diversifying for a more secure future

Sources: Yahoo Finance, Earnings releases, FastGraphs, FactSet Research, Multipl.com, Moneychimp.com
mREIT Yield Q1 Dividend Payout Ratio 10 Year Projected Dividend Growth Historical Dividend Growth
Annaly Capital 11.2% 100% -0.9% -0.1%
American Capital Agency 12.3% 115.4% -1.8% -14.2%
Starwood Property Trust (NYSE:STWD) 8.9% 96.0% 3.5% 9.9%
Blackrock Mortgage Trust 8.7% 95.4% 4.7% -15.2%
S&P 500 2.0% 37.9% 5.8% 5.8%
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As you can see, Annaly is currently paying out all of its core EPS to cover its dividend. However, analysts currently expect the mREIT's payout to continue declining over the next decade, though not as much as American Capital Agency.

While all long-term analyst forecasts need to be viewed skeptically, given the fact that Annaly's dividend is 95% lower today than at its peak in Q1 of 2010, it seems dividend lovers would be lucky to only see such a slow rate of payout decline.

NLY Dividend Chart NLY Dividend data by YCharts

To help secure its dividend, and potentially even allow its future growth, management has embarked on a multi-year, aggressive diversification plan into other credit markets. That includes the highly profitable commercial real estate market.

Sources: Morningstar, Gurufocus
mREIT Operating Margin Net Margin Return on Assets Return on Equity Return on Invested Capital
Annaly Capital 26.6% 1.2% -4.55% -30.1% NA
American Capital Agency NA NA -0.5% -4.1% -28.9%
Starwood Property Trust 50.5% 50.2% 0.4% 9.0% 2.13%
Blackrock Mortgage Trust 72.3% 70.7% 3.0% 11.1% -0.87%
Industry Average -89.3% 11.3% 0.7% 3.5% NA
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This is because, thanks to vastly better loan economics, commercial mREITs such as Blackrock Mortgage Trust and Starwood Property Trust, are able to earn superior returns on investor capital, which has allowed dividends to either remain steady over time, or even rise as opposed to collapsing for predominantly residential mREITs such as Annaly, and American Capital.

STWD Dividend Chart STWD Dividend data by YCharts

To help its diversification efforts, Annaly recently announced the $1.5 billion acquisition of Hatteras Financial (NYSE:HTS), which will increase the size of its more profitable middle market lending, CMBS, and mortgage servicing businesses.

Why is that such a potential boon for Annaly? Because middle market loans and commercial mortgages are generally floating rate. This means rising interest rates would actually help NII, and potentially act as a hedge against the risk of further spread compression in the mREIT's fixed rate residential portfolio.


Source: Starwood Property Trust investor presentation.

Long-term track record shows that buy and hold investors can do great... IF they reinvest the dividends, and add at opportunistic prices

Don't get me wrong, I'm not saying you should stay away from Annaly Capital, far from it. The mREIT's track record over the past 19 years is absolutely phenomenal.

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Source: Annaly Capital Management investor presentation.

In addition, Annaly's foray into non-residential mortgages means its pool of potential business will grow by over $3 trillion through 2020 alone, giving it a very long growth runway indeed.

However, investors need to keep in mind two important things about Annaly's past performance.

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Source: Annaly Capital Management investor presentation.

First, total returns include dividend reinvestment, which is a method of ensuring you buy more shares when the price is falling.

If you reinvest dividends, or better yet, add additional capital during dips, corrections, and even market crashes, then you'll likely do well owning Annaly in a diversified income portfolio over the long term.

Sources: Yahoo Finance, Fastgraphs, Ycharts
mREIT Yield 5 Year Average Yield P/BV Historical P/BV P/FFO Historical P/FFO Average Historical Premium
Annaly Capital 11.2% 13.0% 0.93 0.90 NA 5.5 8.6%
American Capital Agency 12.3% 15.9% 0.88 0.89 10.5 4.4 54.1%
Starwood Property Trust 8.9% 8.2% 1.26 1.23 17.9 16.6 0.6%
Blackrock Mortgage Trust 8.7% NA 1.08 1.32 12.2 15.1 -18.7%
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That being said, while Annaly isn't exorbitantly priced today, it is trading at a premium to its historic yield, price/book ratio, and price/FFO ratio.

Which means you should be prepared for shares to pull back in the next few months or quarters, especially after Annaly's impressive outperformance of both REITs in general, as represented by the Vanguard US REIT ETF (NYSEARCA:VNQ), and the S&P 500, over the past year.

NLY Total Return Price Chart NLY Total Return Price data by YCharts

Bottom line: Annaly Capital Management likely has a bright long-term future, BUT high short-term volatility potential means only risk tolerant investors need apply.

Annaly's stupendous long-term track record of superior total returns indicates that its veteran management team is capable of making this mREIT a potentially great long-term dividend investment. However, given the craziness that we're seeing in US and global interest rates, current and prospective investors need to realize that owning Annaly shares could mean immense short-term pain. Which means only investors with very long time horizons, (5+ years), should invest in this mREIT.

That's especially true given that, at today's valuation, and with the potential for the Federal Reserve to hike interest rates as early as September, Annaly shareholders need to be prepared for potentially strong pullbacks over the next 6-12 months. If you're a long-term believer in Annaly, that would likely make for superior buying opportunities than what you can get today.

Disclosure: I am/we are long STWD.

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.