Annaly Capital Management, Inc. (NLY)
Despite the continued volatility in the mortgage market, Annaly Capital Management, Inc. was able to report 1Q2012 earnings that were above analyst expectations. The stock offers incentives of a lucrative dividend yield of 13.1% for yield-hungry investors, coupled with its ability to sustain such dividends and a low market beta of 0.2. The supportive activity in the real estate mortgage markets represented by a surge in mortgage originations, coupled with an increase in the level of leverage, will further enhance returns for NLY. These are the reasons why we recommend a long position on NLY. However, investors should be on the lookout for a possible impact of the Euro debt crisis and quantitative easing by the Fed. We recommend investors to shortsell the REIT ETF (VNQ) to hedge the long position in NLY.
Company Description
NLY owns and manages, on behalf of its institutional and individual investors, real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations , agency callable debentures, and other securities representing interests in or obligations backed by pools of mortgage loans. It is completely diversified since it operates in residential and commercial mortgages and securities, government and corporate credit markets, equity and debt capital markets and securities lending. The company aims to generate net income for distribution to their shareholders, from the spread between the interest income on Interest Earning Assets and the cost of borrowings, to finance the acquisition of Interest Earning Assets and from dividends received from their subsidiaries.
Stock Price Drivers
Trends in real estate markets: According to a news release by the Federal Housing Finance Agency, house prices in the U.S. have modestly increased in the first quarter of 2012. The House Price Index was up by 0.6% from 4Q2011. This, they say, was largely due to a relatively smaller homes inventory and increased affordability.
The mortgage rate on the benchmark for the 30-year fixed mortgage dropped from 3.91% to 3.89% last week. The rates are expected to drop further.
U.S. mortgage originations are at $318.00b, up from $302.00b one year ago. U.S. mortgage originations purchases are at a current level of $80.00b, unchanged from last quarter. Currently, mortgage originations refinancing is at a level of $239.00b, up from $196.00b one year ago. This represents a change of 21.94%.
All these factors point towards increased mortgage financing, which would enhance the company's ability to generate higher earnings.
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Volatility in interest rates: NLY makes money from the spread it earns, which is the difference in interest it receives on its interest sensitive assets, and the interest it pays on its interest bearing liabilities. Therefore, any volatility in interest rates can affect income, and the market value of NLY's interest sensitive assets portfolio. Interest rates have been on the rise in the previous quarter and the yield curve has further steepened. However, it is expected that the rates will decline and the yield curve will flatten. This will result in decreased interest income for NLY.
Catalysts
Operation Twist: The Fed Reserve plans to buy longer-term treasuries worth $400bn by the end of June and sell shorter-term treasuries, resulting in a flattening of the yield curve. Where it could potentially result in increased prepayment rates and narrower net interest margins for NLY, it also has the potential to appreciate the stock price due to the perceived optimism related to increased general economic activity.
Risk stemming from regulation: Initiatives of the Federal Housing Finance Agency, through its Home Affordable Refinance Program 2 (HARP 2) to help distressed borrowers refinance their mortgages, have the potential to accelerate prepayments for NLY, resulting in higher amortization costs for the company.
Euro debt crisis: A material negative impact on NLY's financing and operations could occur in case the debt crisis in Europe worsens because a few of the European banks' U.S. subsidiaries have provided NYL with financing under repurchase agreements.
Spread Earned
The overall interest rate spread NLY earned remained flat when compared with 4Q2011. During the first quarter of this year, NYL earned a yield of 3.23% on its interest sensitive assets, while the average cost of interest bearing liabilities remained at 1.52%, enabling it to capture a 1.71% interest rate spread.
Earnings
NLY reported earnings for 1Q2012 beat JP Morgan's estimates by a slight margin primarily due to lower prepayments. Net earnings for the quarter ended March 31, 2011 surged by a material 29% to $901.8mn from $699.9mn in the first quarter of last year. This resulted in earnings per common share of $0.92. The material surge, however, was largely due to unrealized gains on interest rate swaps and interest-only agency mortgage backed securities. Going forward into 2012, earnings are expected to increase. Credit Suisse has raised its 2012 earnings estimate for NLY to $1.84 from its previous estimate of $1.80. JP Morgan also raised its 2012 EPS estimates from $1.90 to $2.02.
Leverage
The company's target debt-to-equity ratio is less than 12:1, however, as at March 31, 2012; it is maintaining a historical low leverage ratio of 5.8:1, a modest increase from 5.4:1 as at December 31, 2011. A further increase in the leverage ratio to 6.5:1, expected by Credit Suisse, would enhance returns.
Valuations
The stock is trading at a moderate premium with regards to its book value when compared to most of its peers. The stock is trading at a price-to-book value of 1.05x, as compared to 1.08x and 1.0 for Capstead Mortgage Corporation (CMO) and MFA Financial Inc. (MFA) respectively.
Dividends
The current dividend yield that the stock is offering is 13.1%, which is significantly above the 10-year treasury of 1.59%. The company has an operating cash flow yield of 15%, coupled with a stock beta of 0.22. This means the company has an ability to offer higher risk adjusted return. The company has cash from operations of $2.46b, and paid dividends of $534mn. This clearly shows that the company has sufficient muscle to continue such a dividend policy.
Conclusion
Based on the above analysis and valuations, we recommend a long position in NLY.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
