Annaly's Financials Will Impact Profits

| About: Annaly Capital (NLY)

I, like many investors and homeowners, was affected by the real estate market collapse that started in 2007. As a result of this real estate crisis, many publicly traded companies in the real estate industry saw their earnings and market cap evaporate, which drained the wealth of many private investors and investment institutions. However, looking forward long-term, I envision the real estate market recovering and creating lucrative investment opportunities once more. The following is an analysis of Annaly Capital Mangement (NYSE:NLY), a stock in the REIT industry. Will this stock thrive looking forward?

Annaly Capital Management owns, manages and finances a portfolio of real estate investments. It has a market cap of $15.66 billion and is currently trading close to $16. The stock has increased about 4 percent since last October after declining 15 percent in late September after decreasing the dividend to $0.57 from $0.60 the previous quarter. Most recently, the stock has announced another dividend decrease for Q1 in 2012. This is a dividend cut of $0.02 from the previous quarter. The stock had no major fluctuations because most investors and analysts were expecting a higher cut in dividends, thus the $0.02 dividend cut is seen as good news. With a beta of 0.32 the stock is not very volatile, primarily due to its diversified investments.

Annaly Capital has $994 million in cash and short-term investments and $85.44 billion in short and long-term debt, with 99 percent of this debt being short-term. This implies management is funding day-to-day operations with short-term debt, which can be dangerous if there are serious fluctuations in revenue. As a result, the company's working capital is negative. However, a negative working capital is not always a bad sign because it's also a sign of management's efficiency in a business with low or no inventory.

Taking Annaly's current assets and dividing them by the current liabilities, I find the real estate company has a current ratio of 0.02 and a receivable turn of 7.55, which means the company is collecting receivables about every 49 days. Its debt to equity ratio is 557. Out of its three other competitors, Annaly has the highest price to earnings ratio (43.78). Capstead Mortgage (NYSE:CMO), Impac Mortgage Holdings (NYSEMKT:IMH), and Redwood Trust (NYSE:RWT) have price-to earnings ratios of 7.67, 8.60, and 37.16, respectively. The industry average is 17.10. It is evident that investors are betting a premium because they "might" expect higher growth and better returns from this stock than its competitors.

Recently, Redwood issued bonds attached to new home loans. I think this may spark interest for Annaly and other competitors to consider issuing debt as well. However, because of the low interest rate environment it is more likely they will remain very cautious to engage in these transactions, primarily because investors would require a higher return for their REIT investments. This means REIT's would have increased the interest paid to bondholders at the detriment of a lower interest rate spread.

Over the last twelve months, sales at Annaly increased 33.40 percent, while income decreased 73.80 percent. I calculated an interest coverage ratio (earnings before interest and taxes divided by interest expense) of 1.84. As a general rule of thumb, an investor should not own a stock with an interest coverage ratio of 1.50 as the company may not be generating enough cash to pay interest obligations.

On the other hand, management has been very diligent about managing risk as their interest rate spread has been decreasing. This change has a major impact on earnings because the lower the interest rate spread the lower the earnings, thus lower cash to make dividend payments. This is why management has decreased dividend payments during the last two quarters.

I believe dividend payments might continue to decrease as the Fed trades in some of its short-term bonds for more of the long-term alternatives, which will lower the yield and in turn lower long-term interest rates. For Annaly, this means a lower lending rate, and as I mentioned earlier, will lead to a compression of their interest rate spread (causing lower earnings). While these changes negatively affect earnings of all stocks in the REIT industry, the most efficient management to maintain the highest interest rate spread will attract more investors, thus demand will increase, driving the stock price higher.

The stock issues an annual dividend of $2.28, has an attractive yield of 14.10 percent, and an enormous payout ratio of 659 percent. Competitors Capstead Mortgage and Redwood Trust have yields of 12.80 and 8.70 percent, respectively. Over the last five years cash flow has been somewhat volatile, however over the five year period it has increased at a CAGR of 61 percent. Cash flow for competitors Capstead Mortgage and Redwood Trust increased at a CAGR of 137 and 10 percent, respectively during the same five-year period.

Annaly has appreciated about two percent since the beginning of the year, and although it issues a nice dividend and has an attractive yield, I do not find this an enticing investment considering its staggering debt to equity ratio, its lack of cash to cover its short and long-term liabilities, the recent decrease in dividends, and the dire need to earn higher revenue. The major concern for investors is the impact of potential change in interest rates because REIT's are known for borrowing money to magnify returns. Therefore, I do not consider this stock to be a sound investment right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.