A Closer Look At Annaly Capital Management's Cash Flows

Jun.18.12 | About: Annaly Capital (NLY)

My prior articles focused on master limited partnerships ("MLPs"), an area I have long followed and invested in. My concern with overly concentrating my portfolio in MLPs has led me to examine mortgage Real Estate Investment Trusts ("mREITs") as an alternative yield producing vehicle. Indeed, the current dividend yields on some mREITs exceed the distribution yields on many MLPs including El Paso Pipeline Partners (NYSE:EPB), Enterprise Products Partners (NYSE:EPD), Energy Transfer Partners (NYSE:ETP), Kinder Morgan Energy Partners (NYSE:KMP), Plains All American Pipeline (NYSE:PAA), and Williams Partners (NYSE:WPZ).

I have been evaluating Annaly Capital Management, Inc. (NYSE:NLY), the largest mREIT listed on the NYSE with a market cap of ~$16.5 billion and assets on the balance sheet as of 3/31/12 totaling ~$120 billion. NYL owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations ("CMOs"), callable debentures and other securities backed by pools of mortgage loans.

Total returns generated through 6/15/12 (based on the $16.91 closing price) are summarized in the table below:

From

Share Price Change thru 6/15/12

Dividends thru 6/15/12

Total Return

Approx. Total Return %

12/31/2008

$1.20

$10.21

$11.41

13%

12/31/2009

($0.44)

$5.65

$5.21

10%

12/31/2010

($1.01)

$2.99

$1.98

6%

12/31/2011

$0.95

$0.55

$1.50

15%

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Table 1

Past returns appear to be attractive and the current yield is enticing at 13%. However, investors familiar with my approach know the first question I ask is what portion, if any, of the dividends I am receiving are really "earned". I am leery of investing in entities (publicly traded partnerships or companies) that pay dividends, or fund distributions, by issuing debt or additional equity. In taking a closer look at NLY I encountered difficulties similar to those I faced when reviewing the performance of MLPs. Since money is fungible and the NLY annual report runs over 100 pages that are frequently hard to understand, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.

Several examples can illustrate the complexities. The bulk of NLY's assets consist of mortgage-backed securities and debentures issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) or Ginnie Mae, and of corporate debt (together, "Investment Securities"). These are classified for accounting purposes as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. The effect can be dramatic, as seen in 3Q 2011 when reported losses (realized and unrealized) amounted to 38.8% of the average equity and NLY's net loss for the period amounted to ~$926 million. But there were $1.1 billion of unrealized gains in that quarter that showed up only on the balance sheet, not the income statement. Another example is the subjectivity involved in determining net interest margin, an important performance indicator. Beginning June 30, 2011, NLY reclassified "interest expense on swaps" to "realized gains (losses) on swaps" thus changing the way net interest margin is calculated. Therefore, I find NLY's net interest margins, reported earnings, earnings per share and earnings multiples to be of limited value as indicators of performance or of ability to generate sustainable dividends.

The treatment of borrowing and lending via repurchase and reverse repurchase agreements ("repos") is yet another example. NLY reports cash flow from these activities as cash flows from operating activities when they are performed by RCap (NLY's wholly owned broker-dealer subsidiary), but when they are not performed by RCap, they appear as cash flow from investing activities. Therefore I find NLY's distinctions between the various categories on the cash flow statement (i.e., operations, investments and financing) to be of limited value in understanding NLY's ability to generate sustainable dividends.

In light of these issues, I developed my own definition of distributable cash flow ("DCF"), thus creating a quantitative standard that I view as an indicator of NLY's ability to generate cash flow at a level that can sustain or support an increase in quarterly distribution rates. The definition is relatively simple: net income + amortization (a non-cash item), + losses (or minus gains) on assets & liabilities (also non-cash items), less cash used for working capital.

The results for the past 4 years are outlined in Table 2 below:

12 months ending:

12/31/11

12/31/10

12/31/09

12/31/08

Net income

344

1,267

1,961

346

Amortization

808

669

256

104

Losses (gains) on assets & liabilities

1,707

139

(448)

780

Cash used for working capital

(49)

(2)

(146)

(123)

DCF

2,810

2,074

1,623

1,107

Dividends paid

(2,041)

(1,599)

(1,269)

(975)

DCF excess over dividends paid

769

475

354

132

DCF coverage of dividends

1.38

1.30

1.28

1.14

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Table 2: Figures in $ Millions except coverage ratios

The results for 1Q 2012 and 1Q 2011 are outlined in Table 3 below:

3 months ending:

3/31/12

3/31/11

Net income

902

700

Amortization

290

176

Losses (gains) on assets & liabilities

(456)

(200)

Cash used for working capital

-

(46)

DCF

736

630

Dividends paid

(557)

(408)

DCF excess over dividends paid

179

221

DCF coverage of dividends

1.32

1.54

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Table 3: Figures in $ Millions except coverage ratios

As part of my analysis, I also created a simplified cash flow statement designed to shed light on the sustainability of the dividends by, for example, grouping together and netting out numerous line items that deal with gains and losses that are reported in the income statement but are non-cash items (and therefore reversed out in the cash flow statement). I also separate cash generation from cash consumption and group together and net out numerous line items that deal with cash outflows for assets (e.g., acquiring assets outright or receiving assets as collateral and lending against them) and cash generated by assets (e.g., selling assets outright or giving assets as collateral and borrowing against them). This reduces the over 50 line items in NLY's cash flow statement to just a few.

Results for the past 4 years are outlined in Table 4 below:

Simplified Cash Flow Statement:

12 months ending: 12/31/11 12/31/10 12/31/09 12/31/08
DCF excess over dividends paid 769 475 354 132
Proceeds from assets, net - - 90 -
Convertible Senior Notes issued - 582 - -
Shares issued 5,816 1,331 147 2,244
Other cash generated, net 5 - 5 73
6,590 2,387 595 2,449
Payments for assets, net (5,879) (3,600) - (1,643)
Other cash used, net - (9) - -
(5,879) (3,609) - (1,643)
Net increase in cash & cash equiv. 712 (1,222) 595 805
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Table 4: Figures in $ Millions

In these simplified cash flow statements proceeds from, and payments for, assets contain numerous types of netted items, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; d) principal payments on, or maturities of, securities owned; e) equity investments (including investments in affiliates). Of course, the net increase (decrease) in cash and cash equivalents ties to the company's financial statements.

Results for 1Q 2012 and 1Q 2011 are outlined in Table 5 below:

3 months ending:

3/31/12

3/31/11

DCF excess over dividends paid

179

221

Cash generated by working capital

24

-

Proceeds from assets, net

-

-

Convertible Senior Notes issued (repaid)

-

-

Shares issued

2

2,945

Other cash generated, net

-

1

205

3,168

Payments for assets, net

(255)

(3,093)

Other cash used, net

(12)

-

(266)

(3,093)

Net increase in cash & cash equivalents

(61)

74

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Table 5: Figures in $ Millions

Roughly speaking, on a net basis over the 4-year period of 2008-2011, NLY generated ~$8 billion, raised a further $10.1 billion via equity and debt (of which only $0.6 billion from debt via issuance of senior convertible notes) and used the total of $18.1 billion to increase its portfolio ($12.2 billion) and to pay dividends ($5.9 billion). Over this period, NLY's has demonstrated an ability to generate cash sufficient to both fund dividends and supplement funds raised via issuance of equity and debt in order to increase the size of the investment portfolio.

Clearly the 13% yield does not come without risks and past performance may not be a good indicator of future performance. NLY has benefited from the accommodative stance of the Federal Reserve Bank which, for the past several years, has resulted in a relatively steep yield curve, albeit at low absolute rates. The shape of yield curve and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of return for NLY which relies primarily on short-term borrowings to acquire Investment Securities with long-term maturities. Accordingly, profitability may be adversely affected if short-term interest rates increase. NLY's Form 10-K lists numerous other risks, including the health of its Chairman, CEO and President.

On the other hand, NLY is led by a highly experienced, long-tenured, management team that has managed a wide range of interest rate environments since the initial public offering 1997. Management has been keeping leverage at the low end of its 8:1 to 12:1 leverage band since 2007. Reduced leverage reduces both interest rate risk and systemic risk (e.g., crisis in Europe, regulatory pressures for mortgage finance reform, future of Freddie Mac & Fannie Mae, SEC review of the exemption granted to mortgage REITs from the 1940 Act which would cause them to be considered as mutual funds). It has brought the debt-to-equity ratio down from over 6.3:1 in 2009 to 5.8:1 as of 3/31/12 (5.4:1 as of 12/31/11) and is keeping the duration at a short 1.2 years as of 12/31/11. Duration is the length of time required to recoup losses caused by a percent increase in short and long-term interest rates (losses are recouped by reinvesting at higher interest rates). Giving effect to swap transactions, NLY reported average duration (0.4) years as of 12/31/11. The negative number indicates that, giving effect to swap transactions, the duration of NLY's assets is shorter than that of its liabilities.

As can be seen in Table 1, the bulk of investor returns have come from dividends rather than capital appreciation. Looking ahead, I don't expect this to change. In fact, if management's measurement of net interest margin is correct, the current level of interest margin (1.71%) and leverage (5.8) indicate a return on equity of about 9.9%, so a ~3% price decline for an overall return of ~10% would not surprise me.

Disclosure: I am long NLY, EPB, EPD, ETP, PAA, WPZ.

Disclaimer: Investors should perform their own due diligence and assess their individual tolerance for risk before buying or selling the shares.