Annaly Capital Management (NLY), currently trading around $16, is a mortgage real estate investment trust (mREIT) that owns and manages a portfolio of agency mortgaged-backed securities (MBS). These are securities that are originated by Freddie Mac (OTCQB:FMCC), Fannie Mae (OTCQB:FNMA) and Ginny Mae. Annaly has a market capitalization of $16 billion. The company buys pools of mortgage loans with the intent of generating income for stock holders from the spread between the interest on the MBS and the cost of financing the purchase of the mortgages. Annaly does not originate loans. Instead, the company purchases its investments from third parties, primarily Freddie Mac, Fannie Mae and Ginnie Mae. Annaly's investment policy requires that 75% of its assets must be invested in high quality MBS. The company defines high quality as securities that are rated within one of the two highest rating categories of a nationally recognized rating agency, such as Standard and Poor's. The remaining 25% of assets must be invested in other real estate assets that are less than high quality, but still considered investment grade. As of December 31, all of Annaly's MBS' carry a AAA rating, with 90% of investments being fixed rate pass through certificates.
Before I go on with my discussion of Annaly, I want to take a look at the business model of mREITs. Annaly is an mREIT that invests in agency backed securities. Annaly's business model is pretty straight forward. Annaly uses funds borrowed at a lower interest rate to purchase agency backed mortgage securities that pay a higher interest rate. The MBS that Annaly purchases are backed by the federal government and are considered to be risk free, the equivalent of Treasury Bonds.
On February 7, 2011, Annaly Capital Management released 4th-quarter earnings. Annaly earned $0.46 a share versus at $1.94 from one year ago. Annaly missed the consensus estimates of $0.54. During the 4th quarter, Annaly saw interest expense increase by 14% from one year ago. Interest expense was $130.1 million in 4th quarter 2011 compared with $111.8 million for the previous year. Annaly also completed three equity offerings during 2011. With the improvement of capital markets, Annaly issued offerings in January, February, and July, bringing in $4.7 billion. Annaly quickly put this money to work and it is believed that new investments will have a positive impact on earnings as the spreads on the newer investments should be wider than they have in the recent past. In 2011, Annaly's interest rate spread narrowed to 2.04%. EPS, excluding gains and loses on investments, was $2.57, down from $2.67 in 2010. ROE improved to 16.5%, up from 16.35% the previous year. S&P estimates that Annaly will earn $2.20 a share in 2012. That gives the company a forward PE of 7.3. Annaly trades around $16 and pays an annual dividend of $2.44, giving the company an approximate dividend yield of 15%.
Even though Annaly funds its assets with short-term repurchase agreements, Annaly's balance sheet is relatively healthy and has a better debt-to-equity ratio than a majority of its peers. Because Annaly invests in government backed MBS, Annaly faces substantially less credit risk than its peers. Annaly maintains a debt-to-equity ratio between 8:1 and 12:1. In 2011, the company deleveraged to about 5.4:1. During the December quarter, Annaly reduced its investment portfolio by 2%. Management has stated it will maintain a more conservative posture until the interest rate environment improves. Interest rate spreads are expected to be 1.8% in 2012 down 2.04% in 2011. At then end of 2011, Annaly had $12.2 billion under management for third party investors. These holdings are expected to generate operating fees of around $87 million in 2012. Earnings estimates of $2.20 for 2012 take into account lower interest rate spreads and dilution from equity issuance during 2011.
Annaly also makes money through its Fixed Income Discount Advisory Company. This division collects fees by advising Chimera (CIM). This diversifies Annaly and, in the future, will be the primary source of growth for the company. Annaly's major line of business growth is stifled by the amount of profit it has to pay out to shareholders to retain its tax status as a REIT. Annaly can be considered somewhat expensive compared with two of its main competitors: Equity Residential (EQR) and Boston Properties (BXP). Equity Residential trades around $60 and Boston Properties trades around $104. However, you can't look at the price of a stock when considering its value. Annaly traded at 2.82 times its 5-year PEG with a 5-year earrings forecast of only 2% for the company. Residential equities are trading 2 times their 5-year PEG, with expected earnings growth of 7% during the next 5 years. Boston Properties has the highest PEG of the three at 3.71, and the highest 5-year earnings forecast of 5%. Equity Residential only pays a 3.9% dividend, and Boston Properties pays a dividend yield is 2.1%. I believe Annaly should be trading at a relative premium to both Boston Properties and Residential Equity. With a 15% dividend yield, I am willing to give up some value for the extra income. I want to point out that Annaly is not purchased for its potential appreciation and value. Annaly is an income stock and should be treated as such. The stock price isn't going to move much, which makes it hard to build an argument that Annaly is overpriced compared with other mREITs.
I also want to point out that mREITs are exposed to risk, and this fact should not be ignored. Annaly's management team does an excellent job of protecting investors from unnecessary risk, but even Annaly is exposed to risk. One risk that Annaly does face is a change in the way mREITs are taxed. As long as they pay out 90% of the company's income, these distributions are taxed at the share holders' individual tax rate and are not subject to corporate taxes. If the tax status of mREITs changes and they are taxed as a corporation, this would negatively impact Annaly's earning and its ability to maintain such a high dividend yield. If the dividend were cut substantially because of changes in tax status, investors would see the share price of Annaly drop. The other major risk that Annaly faces is a narrow interest rate spread. Annaly has experienced this to some degree with current interest rates being so low, and management seems to be managing this risk very well. It is my belief that future interest rates have nowhere to go but up. As long as short-term rates remain constant and longer-term rates increase, Annaly will maintain the ability to pay the current dividend.
Over the long haul, Annaly's conservative posture will allow the company to maintain a strong position and increase its portfolio when the MBS environment improves. With a steady 14% to 15% dividend yield, I expect Annaly to trade in the $15 to $18 range for the next 12 months. Again, you are not buying Annaly for its growth potential. Because of its status as an mREIT, Annaly is limited in its growth prospects because of the payout requirement. I think that Annaly, with its conservative approach to investing, is a good play for investors looking for income.