Why Is Annaly Capital Still The Best Dividend Play?

Jul.19.12 | About: Annaly Capital (NLY)

Annaly Capital Management, Inc. (NYSE:NLY), with a dividend yield of 12.8%, is one of the highest dividend paying mortgage REITs in the U.S. financial sector. The company demonstrates enough financial strength to continue its dividend distribution for the foreseeable future, and has adopted several strategies, as mentioned in the thesis below, to reduce its sensitivity to interest rates and other housing and mortgage market activities. Our estimates have led us to believe that the company is best positioned to face the challenge of decreasing interest rates. Therefore, we reiterate our buy rating for Annaly Capital.

U.S. Economy and Housing Sector

While the U.S. economy is not showing any signs of relief, its housing sector—which collapsed six years ago—seems to be gaining momentum. Bernanke, in a testimony on Tuesday, said the U.S. economy was suffering due to a spillover from debt-stricken Europe, as well as the path that the U.S. fiscal policy had taken. Since the U.S. housing market has condensed in size, analysts believe if the country falls back into a recession, housing will provide little support.

U.S. jobs, factory output, and retail sales data have shown no improvement, intensifying concerns. Among others, the data on unemployment claims that is due tomorrow will partially decide whether new monitory stimuli will be introduced by the central bank. Housing starts for the month of June this year were the fastest in over three years. Data released by the Commerce Department showed a surge in housing starts of 6.9% for June. The Mortgage Banker Association added that mortgage applications, driven by record low 30-year mortgages, also surged last week.

Company Overview

Annaly invests exclusively in agency-sponsored real estate related investments, including collateralized mortgage obligations, callable debenture, and above all, mortgage pass-through securities. The company derives benefits of diversification. It engages in corporate and capital markets (equity and debt), credit markets (government and corporate), and securities lending, while its portfolio of investments is engaged in residential and commercial mortgages. Its primary source of income is the difference between the interest income it earns on its mortgage portfolio, and the cost of borrowing. The difference is called the interest rate spread, or margin.

Risk Mitigation Strategy

Since all of the company's assets portfolio and liabilities are financial in nature, its earnings are impacted by changes in interest rates and other U.S. housings/mortgage market activities. In order to mitigate the risk of changes in interest rates, and the resultant impact on net income, the company attempts to match adjustable-rate assets with variable-rate borrowings. For this purpose, the company uses swaps with a national principal of $42.1b, where it is obliged to pay fixed, and receive floating, based on one-month LIBOR.

The average pay rate that the company paid during the first quarter was 0.13% below what it paid during the last quarter of the prior year. The decline came as a result of higher pay rate swaps being terminated, matured or replaced with lower pay rates. To reduce the effect of accelerated prepayments on mortgage-backed securities, the company aims to match securities purchased at a premium, with those purchased at a discount.

Interest Rate Sensitivity

Annaly, in its quarterly filings with the Securities Exchange Commission, mentioned that the market value of its portfolio would increase by 0.69% if interest rates decrease by 50bps. The 30-year treasury rate at the end of March 31 was 3.35%; however, due to continuous efforts by the Fed, the rate has declined to 2.59% as of July 18. This is a decline of 76bps. The company's asset portfolio will experience a surge of 1.04% due to the decline in interest rates. Our estimates have led us to believe that the company will experience a decline in the interest income that it will earn during the second quarter of this year.

Our estimates have been drafted after having looked at the interest rate sensitivity gap for the company's rate-sensitive assets and liabilities. Annaly's interest rate sensitivity gap was $16.7bn by the end of March 31, 2012. A positive gap will translate into reduced income for the company in the second quarter. Considering only the decrease in the 30-year treasury, the worst case scenario would be that the company's interest income decreases by $127mn. This translates into a drop of $0.13 in the EPS for the second quarter. Analysts have a second-quarter mean estimate of $0.49, showing an estimated drop of $0.06. However, the reduction in income in the worst case scenario will be not enough to threaten shareholder distributions in the foreseeable future.

First-Quarter Results

The company presented strong results for the first quarter of 2012. Lower prepayments, unrealized gains on interest rate swaps, and interest-only agency MBS drove the quarter's earnings, which beat estimates. Earnings reached $901.8mn or $0.92 per share, up by 29% from the prior year. The company has shown an 11.6% growth per annum in its earnings over the past five years, while only a 29% growth is expected over the next five years.

Dividends

Mortgage REITs are famous for their high shareholder distribution. Annaly's dividend yield of 12.8% is one of the highest among U.S. REITs. The distributions are also sustainable, since the company has a 15% operating cash flow yield. Annaly generated operating cash flows of $2.46bn, while it paid dividends of $556mn. This shows that investors who are looking for regular income can expect the dividend to continue in the future.

Valuations

The stock, with a price-to-book multiple of 1.06x, is largely in line with the multiples of its major competitors, namely American Capital Agency Corp. (NASDAQ:AGNC) at 1.05x, and Hatteras Financial Corp. (NYSE:HTS) at 1.08x.

In conclusion, we recommend Annaly's stock for those investors who are looking for regular sustainable income.

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