mREITS are often criticized for their "cult followings", "blind" trust in management, and earnings uncertainty. While I have articulated in past why investors should be afraid of the dividend cuts at Annaly Capital (NLY) and sister company Chimera Investment (CIM), I think it is important to report both sides of the story.
In this article, I will run you though my free cash flow model on Annaly and present the bullish thesis. It is important to bear in mind that Annaly delivered around $2.4B in free cash flow during FY2011 and the company trades at just 6.6x that multiple. Free cash flow may have plummeted from FY2009-2010 levels of $10.8B, but it is still high enough to warrant skepticism about opening a short position.
First, let's start with an assumption about the top-line. Annaly finished FY2011 with $3.6B in revenue, which represented a 33.4% gain off of the preceding quarter. Over the next half decade or so, I model per annum growth trending around 3%. This figure is around 11,000 basis points what is expected for the S&P 500.
Moving onto the cost-side of the equation, I model cost of goods sold as 41% of revenue versus 6.2% for SG&A and 0% for capes. Taxes are estimated at around 5% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -2% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a bearish WACC of 12%, the rough intrinsic value of the stock is $21.25, implying 30% upside. The market seems to be factoring in a WACC of 15%, which is mostly assigned to high-risk venture plays that have little operating history. In any event, my model assumes low free cash flow compared to what we have seen in the recent past. That is, it forecasts $2.2B in free cash flow for FY2017 - slightly below FY2011 levels.
All of this, however, falls within the context of management opting for story telling. At the recent earnings call, CIO Michael Farrell did not say one thing about operating performance (nor did the only other speaker, the operator) and titled his story "too much of a good thing":
Most humans are uncomfortable in silence. To avoid it, modern humans subject themselves to constant stimulation, mostly in the form of information. We used to simply read a few newspapers each day or watch TV. Now we are bombarded with emails, texts, blog posts, newsletters, tweets, Internet news outlets and cable TV channel for every possible purpose.
I will leave it to your imagination to figure out where the story goes from there. Although I see reasons to be optimistic about Annaly, managerial communication is not one of them. No matter, the free cash flow story is still better than many bears let on.
From a multiples perspective, Annaly is also attractive. It trades at 33.4x past earnings but 8x forward earnings. Chimera trades at a respective 5.5x and 6.5x past and forward earnings.
Consensus estimates for Chimera's EPS forecast that it will decline by 28.8% to $0.47 in FY2011 and then by 6.4% and 2.3% more in the following two years. Many, however, argue that mREITs can't be valued by their earnings. Currently Chimera offers a dividend yield of 15.4%, which is 1920 basis points higher than that of Annaly. Interestingly, both of these dividend yields are lower than that of Apollo Residential (AMTG), which is a much less followed company.
Apollo currently offers a dividend yield of 16.4% It trades at a respective 17.6x and 6.6x past and forward earnings. Unlike Chimera and Annaly, Apollo is actually rated near a "strong buy" (source: NASDAQ). For investors looking for financial real estate exposure, Apollo is thus also worthy of greater due diligence.