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Annaly Capital Management (NLY) on August 1, 2012 surprised analysts when it reported its performance for the second quarter of the current year. Both revenues and earnings figures were far above what analysts had expected.

The table above illustrates how the company's reported performance exceeded its expectations. The company earned $546 million or $0.55 per share on revenues of $720 million. Both the top line and bottom line beat analyst estimates by 29% and 13%, respectively. The following table gives the details about selected income statement items, alongside key matrices for Annaly Capital.

Sequential Financial Review

It is evident from the table above that during the second quarter, despite a decrease in the net interest spread, the company was able to generate interest income of $886 million, 4% above what it generated during the first quarter of the current year. This was primarily the result of a 3% increase in interest income accruing from investments, and a significant 420% surge in interest income accruing from U.S. treasury securities.

When comparing sequentially, the 25% surge in interest expense was primarily associated to a 23% surge in the interest paid on repurchase agreements, and a 28% surge in interest paid on convertible senior debt. Fair value for repurchase agreements increased 7.6%, and during the second quarter, the company issued $750 million worth of new convertible senior debt, resulting in the surge in interest expense.

The surge in interest income for the second quarter offset the effect of a surge in interest expense, resulting in a flat net interest income of $720, compared to the previous quarter. Earlier in a report on Annaly Capital, we noted that one of the most significant risks that the company faces is the interest rate risk. We thought the company will experience a drop in its interest income due to a decrease in the net interest margin. However, despite a 17bps drop in the net interest spread, the company was able to keep its net interest income flat.

During the quarter, the company was able to manage its operating expenses efficiently, which resulted in a 5% decline in the total operating expense, compared sequentially. This decline in operating expense and the surge in the top line helped the company post a bottom line of $546 million, up 3% when compared to the first quarter.

The net interest margin that the company earned during the quarter dropped 17bps to 1.54%. This was the result of a flattening yield curve due to continuous efforts made by the Federal Reserve Bank. For the same reason, yields on assets, which are long term in nature, fell 19bps to 3.04%. The nature of interest being liabilities in the short term, with 216 days of weighted average maturity. The cost of funds dropped marginally by 2bps during the second quarter. The company maintained the same leverage, reflecting the continuation of its conservative strategy.

Although 92% of the company's asset portfolio is composed of fixed rate agency mortgages, it hedges 41% of the entire portfolio for interest rate risk, which is why the company experienced an increase in its book value of only 30bps (due to a decline in interest rates).

Dividends

The stock maintains a dividend yield of 12.71%, sufficiently attractive for investors looking for regular income. The company had a free cash flow yield of 17.35%, meaning investors can expect shareholder distributions to continue for the foreseeable future.

Valuations

The stock has attractive valuations when compared to its major peer. It is trading at a premium of 7% to its book value. However, when compared to one of its major competitors, American Capital Agency (AGNC), the stock trades at an 11% discount on P/B value multiple. Historically, the stock has traded at a book value multiple of 1.16 times. With 2012 earnings estimate of $16.15, we expect the stock to trade at around $18.7.

Capstead (CMO), another major mortgage REIT in the U.S. financial sector missed analyst estimates when it reported its performance for the second quarter. Capstead, however, is not a direct competitor of Annaly, as the former invests exclusively in adjustable rate mortgage securities. American Capital Agency , one of Annaly's direct competitors, is scheduled to report on August 2, 2012 (today).

Outlook

The Fed has recently signaled its intention of taking more steps to stimulate the sluggish U.S. economy, which has been hit by stubbornly high unemployment and weak retails sales, pushing analysts to lower their GDP forecasts for the country to as low as 1.6%. Besides bringing down the long term rates, the Fed is also weighing prospects of a short term rate cut. Some sort of an initiative from the Fed is widely anticipated, and in the event of a short term rate cut, we believe Annaly Capital would benefit alongside the rest of the mortgage REITs. Cheap borrowing costs would enhance interest rate spreads for these companies.

In conclusion, the company maintains a strong balance sheet, and has been able to beat analyst estimates despite a decrease in its interest spread, due to the declining interest rate environment. Going forward, further action by the Fed is highly likely, which will lead to a decline in interest rates. In the event of a further decline in interest rates, the current dividend yield of 12.7% that the stock offers will be even more attractive. Besides the shareholder distributions, investors can also expect a price appreciation. Therefore, we reiterate our buy rating on the stock.

Source: Annaly Capital Earnings Review: Investors Can Expect Price Appreciation