Annaly Capita: Why Sugar Coat It?

| About: Annaly Capital (NLY)

Summary

Annaly Capital is one of my longest and oldest holdings.

Q2 earnings are out and I discuss the results.

What to look for going ahead.

Annaly Capital (NYSE:NLY) is one of my longest and oldest holdings. I have written about it many times over my writing career. Rather than repeat key background information that can be found in a multitude of my prior pieces, I will get straight to the point here. The mREIT sector has begun to rebound after three years of pain. It has been a tough hold in this name, but over the last two years, the stock has mostly traded sideways, and for an income name, this is a good thing. But now it is near a 52 week high and could push higher. To me that is simply a bonus, because you are collecting a massive dividend and that is why we own a name like this. Provided the company is covering its dividend, this is welcome.

Make no mistake Annaly and other in the sector have had to contend with a high constant prepayment rate in the sector as well as interest rate fears. But is the company delivering? To answer this question directly we should review the just reported Q2 earnings. In my estimation the company delivered a decent report that was about what was expected, and it was also in line with analyst estimates. First, it saw a GAAP net loss of $279 million, or $0.32 per share this quarter compared to last quarter which saw a GAAP net loss of $868 million, or $0.96 per share. Let us dig deeper.

I want to point out that in prior articles I had called out some "financial wizardry of the company," which was really more akin to "financial BS" if I am being honest. The company was using all these adjustments, making changes to normalize earnings. Just report the facts! That was my take. Well, management has heard the call. In the release we learned:

"Beginning with the second quarter 2016 results as reported herein, the Company has modified its non-GAAP disclosures to discontinue use of normalized financial metrics. The Company will continue disclosing core financial metrics, with core earnings redefined to also exclude the component of premium amortization representing the quarter-over-quarter change in estimated long-term constant prepayment rates ("CPR") (referred to herein as premium amortization adjustment ("PAA"))"

So that is welcomed news as explaining these normalization factors was difficult, and interpreting them was near impossible. That said we need to gauge dividend coverage and so the net income/loss doesn't tell us much. The more appropriate measure that I like to focus on is the core earnings. Annaly's core earnings came in at were $282.2 million or $0.29. I was not pleased with the quarter-over-quarter decline from the $292 million, or $0.30 per share in core earnings in Q1. Annaly is skating very close to its dividend of $0.30. As I have said before, for the dividends to be secure moving forward, we need this core income to rise. So, let us look into the critical metrics for mREIT's.

The net interest rate spread

The average yield on interest earning assets was 2.48 and the average cost of interest-bearing liabilities, including interest expense on interest rate swaps used to hedge cost of funds, was 1.80%, which resulted in a net interest spread of 0.80%. That is pitiful. Anything under 1% is exceptionally weak. Using a slightly adjusted core spread, the core average yield on interest earning assets was 2.95%, which resulted in a core net interest spread of 1.27%.

Constant prepayment rate

This is now the most critical indicator to watch, as it impacts all others. And as you know, I have been concerned about prepayments, and these have crushed earnings in the last two quarters. That said, Annaly Capital's portfolio saw its average constant prepayment spike back up to 12.7%, from the 8.8% in Q1 2016. Recall, I had predicted the constant prepayment rate would level off and drop for the sector in early 2016 then ramp back up. This is because the CPR is often a trailing indicator. This rise drove the net interest rate spread lower and hit net interest income. Ideally, I would like to see 5-6%.

Leverage

Leverage, or debt-to-equity, is simply the term for borrowing money and leveraging exposure to certain investments. What is interesting here is that company lowered exposure to risk in 2014 and most of 2015, but has now stepped up its exposure. The leverage ratios, or the ratio of Annaly's debt-to-shareholder equity, for all of the last 9 quarters were:

· Q2 2014 - 5.3:1

· Q3 2014 - 5.4:1

· Q4 2014 - 5.4:1

· Q1 2015 - 4.8:1

· Q2 2015 - 4.8:1

· Q3 2015 - 4.8:1

· Q4 2015 - 5.1:1

· Q1 2016 - 5.3:1

· Q2 2016 - 5.3:1

As you can see, Annaly is still more aggressive this year versus last year. Still, it is levered less than the sector average of about 6.0:1. So far the leverage has not helped the company improve on its performance, but keep an eye on this metric moving forward.

Book value

In general, book values have been falling sector wide for years. However, a few companies have started to turn the tides, at least in recent months. This was not the case for Annaly. Book value was $13.10 to start 2015, but fell to $12.88 as of the end of Q1 2015, dropped to $12.32 in Q2 2015, fell another 3% to $11.99 in Q3 and dropped to $11.73 in Q4. Last quarter in Q1 it fell another to $11.61. Here in Q2 it fell another 1% to $11.50. Based on a share price of $11, the company has really closed the discount-to-book gap to just 4.5%.

Conclusion

Why sugar coat it? I was not pleased with the quarter. It was not terrible, but it was not good. All that said, I am pleased with the company deciding not to present the so-called normalized figures anymore. I am also feeling the dividend, while in some risk, is secure for now. Still, with the recent share price appreciation we got a bonus on top of being paid a hefty dividend for what was sideways action in the stock. This action sets up interesting potential to make profit by trading around a core position. While I think this can be done, I am content simply holding and reinvesting the dividends, waiting for the eventual strong turn around. I am holding at this point.

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."

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.