Did Annaly Capital Management Have A Great Awful Quarter?

| About: Annaly Capital (NLY)

Summary

Share price returns for the quarter were clearly negative, but estimated book value returns look solid.

By my estimates, NLY’s BV should be around $12 and probably a bit higher.

The increase in Annaly Capital Management's discount to trailing book value is a warning sign for the sector.

So far the current environment should support the dividend for another quarter.

Any outcome in the election is likely to lead to some angry investors and could create another risk factor in a sector investors don't understand.

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Annaly Capital Management (NYSE:NLY) had a great quarter, or a rough quarter, depending entirely on your point of view. Shares closed trading at $10.37 on 10/3/2016. At the end of the second quarter, they closed trading at $11.07. From the perspective of the investor watching the value in their account, this was a rough quarter. A decline of $.70 is more than the two dividends paid during the quarter. Those two dividends combined to be $.30 for the quarter.

How Could it be Good?

I track estimated book value for some of the mortgage REITs. By my estimates, Annaly Capital Management's book value should be in the ballpark of $12.00 even after paying out that dividend of $.30. Of course, estimates on assets such as the first loss tranches for CMBS are rough, since performance of the loans in their pool could cause their position to move in a manner that is materially different from my estimates. When NLY carried a simpler portfolio, estimating their BV was easier. I think there is a decent chance that the BV comes in above that estimate.

Updated Note: The value of $12.00 as a rough BV estimate is based on the end of quarter values, not on 10/14/2016.

If an investor was tracking TER (total economic return) which is the dividend paid plus the change in book value, then the estimated performance for the third quarter would look very strong. On the other hand, if the investor was only using the value in their brokerage account, then the performance looks ugly.

For what it is worth, my models are not revaluing the positions from Hatteras Financial Corp. (NYSE:HTS). Remember, NLY purchased HTS. I believe the transaction will be a net positive based on the way MBS and LIBOR swaps moved over the course of the quarter and the discount NLY achieved in negotiating the acquisition price.

Implications

In my quick and dirty discounts, I found NLY had the worst performance from the end of Q2 through the end of Q3 for "price to trailing book value." That concerns me because I see Annaly Capital Management as one of the leaders for which way the sector is going. It looks like capital is flowing out of the sector now rather than into it.

I'll be looking carefully at the relative discounts in the sector and assessing the amount of risk. As it stands, I think NLY represents a better investment than a large chunk of the sector. That is a negative sign for the sector, but it makes NLY more attractive by comparison. I generally avoid putting any strong rating on the common stock of Annaly Capital Management because they can move ahead of the rest of the sector. Instead, I tend to focus on relative values. For instance, if Annaly Capital Management suddenly traded up to $12.00, I would expect the rest of the sector to see some strong rallies.

This should not be viewed as a prediction or a $12 price target. It is neither of those things.

My Strategy

Rather than going into the common stock of Annaly Capital Management, I went into the preferred shares and built a large position in NLY-E. While I'm concerned about when investors might decide to panic about holding the common stock of mortgage REITs, I'm not concerned about the 7%+ yields on preferred shares going out of fashion.

Update: At the initial price of $10.37, I was not willing to assign a buy on the common stock. Very shortly thereafter shares went under $10.10 and I put out a buy rating on the common.

Update: I also recently acquired some shares of NLY-D from the high $24.90s to $25.

Dividend So Far

With the fourth quarter just barely under way, the odds of the dividend being sustained look good so far. A sudden change in the yield curve could change my outlook, but so far I'm not seeing anything that would make me think NLY would chop their quarterly dividend.

Beware Of Book Value Fluctuations

The spreads between MBS and LIBOR swaps could widen as easily as they shrank last quarter. Credit sensitive positions could decline even faster than they climbed. In a nutshell, the BV gains I'm projecting so far could be erased in any future quarter. Book value should be one major piece investors use in assessing a mortgage REIT, but it shouldn't be the only one. It is also important to assess the portfolio and the size of the spreads currently offered between different asset classes and hedges.

Election Impact

I'm not interested in getting into partisan politics. I think most readers can agree with me that at least one party will be very disappointed with the results. Given how inefficient prices in the mREIT sector can be, either outcome could be seen as a negative. That isn't a situation that makes me want to pour money into common stock in an inefficient sector trading at relatively higher prices compared to last year.

Overall Outlook From 10/03/2016

Shares aren't quite as attractive as they were at $10.50 before they went ex-dividend, but they are better than average. If Annaly Capital Management dips much further (last seen at $10.37), I will contemplate shifting capital out of other positions if their prices are holding up better than NLY. In that scenario, I might move the capital into NLY.

I do not expect to sell any shares of NLY-E. If they go on sale, I might acquire more.

This stance can be treated as neutral with a slight bullish tint based on superior value relative to several peers. By $10.00, my view on NLY would probably shift to a positive rating.

Update to 10/14/2016

My view did shift to a positive rating when shares were slightly over $10. At the moment of writing this update, share prices are $10.17. I'm willing to put that buy rating out there again because I think there is still enough upside in the position. I'll go for another bullish rating, though it is still only moderately bullish. A quick run-up in the share price would drop my view to neutral with a bullish tint.

I may buy or sell anything in the immediate future. Current positions are long NLY-D and NLY-E.

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Disclosure: I am/we are long NLY-D, NLY-E.

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. Tipranks: Assign one additional buy rating to NLY.