Annaly Capital (NYSE:NLY) remains one of my longest and oldest holdings. I have written about it many times over my writing career, though of late have not covered it much. 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 this year 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. Strike that. It is a great thing. But with a changing rate environment, the short term could be turbulent, but the longer term looks bright. This could mean share appreciation. 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, growth is always welcome.
The biggest issue facing Annaly and the sector as a whole is a high constant prepayment rate, in addition to interest rate fears. But is the company delivering? To answer this question directly, we should review the recently reported Q3 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 swung from a GAAP net loss of $279 million, or $0.32 per share, last quarter to see GAAP net income of $731 million or $0.70 per share. That said we need to gauge dividend coverage and so the net GAAP 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 $0.29 per share. 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. But to understand where the income is coming from, let us look into the critical metrics for mREITs.
The net interest rate spread
The average yield on interest earning assets was 2.70% and the average cost of interest-bearing liabilities, including interest expense on interest rate swaps used to hedge cost of funds, was 1.57%, which resulted in a net interest spread of 1.13%. This is a great turnaround from the 0.8% last quarter. Anything under 1% is exceptionally weak. Using a slightly adjusted core spread, the core average yield on interest earning assets was 2.72%, which resulted in a core net interest spread of 1.15%. This is moving in the right direction, significantly.
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 up to 15.9% from 12.7% in Q2 2016. Recall, I had predicted the constant prepayment rate would rise the second half 2016 then level off. This is because the CPR is often a trailing indicator. Ideally, I would like to see 5-6% on this measure, but the entire sector is facing pressure here. The good news is that it did not pressure the spread, and subsequently net income. Though if the CPR was lower, the spread would likely have been higher.
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 in 2016 and held it steady. The leverage ratios, or the ratio of Annaly's debt-to-shareholder equity, for all of the last 10 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
- Q3 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 to markedly, but keep an eye on this metric moving forward. The company remains more defensive that it has been historically.
In general, book values have been falling sector wide for years. However, a few companies have started to turn the tides, In the case of 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. In Q1 2016, it fell another to $11.61. Just last quarter in Q2 it fell another 1% to $11.50. Now here in Q3 book value expanded, and expanded quite nicely. It grew 3% to $11.86. Based on a share price of $10.07, the discount-to-book is still attractive, coming in at $1.79 or 15%.
I have to admit I am pleased with the quarter. Are we turning the corner? Is this the start of a strong rally in the spread and book value, and subsequently share price? We will need more quarters of data to make this determination. But it bodes very well. With the recent share price action being mostly sideways between $10 and $11, the entry point is attractive for an add-on or a new position. My one concern remains that core income figure. It has got to improve as it is skating too close to the dividend payment. While I think this can and will be done, I am content simply holding and reinvesting the dividends, waiting for the eventual strong turn around. I am holding at this point, but at $10, this is attractive.
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.