Annaly Capital Management: Point-CounterPoint With Skyler Greene

| About: Annaly Capital (NLY)

Skyler Greene and I have collaborated on a pair of articles in which the "pros" and "cons" of Annaly Capital (NYSE:NLY) are reviewed.

Obviously, with my well-established (review this recent article) admiration for Annaly the company, as well as the stock, I am taking the pro side, and will do so by rebutting common bearish arguments. .

Skyler has offered his cautionary views in his own piece.

Argument 1: You Can't Value mReits with Typical Metrics

The bears argue that due to the different business model, you can't value mREITs with typical metrics. GAAP EPS is essentially useless - instead, a metric called FFO (Funds From Operations) is often used. Annaly is one of the more expensive mREITs based on the Price-to-FFO metric. As shown in this article from June [add link] , Annaly's Price/FFO is 4.3X, significantly higher than that of peer mREITs:

  • American Capital Agency (NASDAQ:AGNC): P/FFO 2.5X
  • Capstead Mortgage Corp (NYSE:CMO): P/FFO 2.6X
  • Hatteras Financial (NYSE:HTS): P/FFO 2.5X
  • Anworth Mortgage Asset Corporation (NYSE:ANH): P/FFO 2.6X

Regarded Solutions: Why pick apart where funds are coming from, in any company's operations. If they got 'em then why not use 'em? Personally, while obviously the numbers speak for themselves, Annaly's use of a lower level of risk actually allows them to have a somewhat higher metric here. To me, this is a plus. They have the money and they give it to shareholders. Pretty good concept, wouldn't you say?

Argument 2: Annaly's Persistent Share Dilution

"Annaly has a history of share dilution, such as the conversion of preferred stock to common stock."

This trend looks to continue, as Annaly recently announced issuance of Series C Cumulative Redeemable Preferred Stock. Here is the link to the filing dated May 16th with the SEC.

Regarded Solutions: I love charts don't you? We can make them look anyway we want. Actually share dilution has been dropping for Annaly this year. They have not issued a secondary stock offering, have used most of their "shelf" shares (125 million), and conversion of preferred into common shares has actually helped the share price of the common stock. With the increase in book value and the share price continuing to increase, there might be room for a secondary at some point but in my opinion it could offer a compelling entry point for newer investors.

Directly pertaining to that new Series C Preferred Stock, I view this as another positive! With only 12.6 million shares being issued, the dilution of "interest" is hardly a blip, plus with a 7.65% dividend yield and a share price more than $7.00 per share higher, more folks could see the common shares in an even more attractive light.

Argument 3: Dividend Yield: Not Guaranteed

Skyler, and others, have argued the quoted dividend yield for an mREIT is somewhat of a ballpark figure. Unlike traditional dividends paid by companies like Procter & Gamble (NYSE:PG), mREIT dividends aren't constant. Rather, they depend on quarterly results.

Since peaking a few years ago, Annaly's dividend has been declining along with most of its peers. Why? Well, in the early years of a low interest-rate environment, mREITs can take advantage of higher-than-normal spreads. However, over time, the spread compresses, reducing the potential for juiced returns.

Worse, looking at the long term chart of the dividend vs the federal funds rate, there's a fairly strong inverse correlation.

When the federal funds rate goes up, Annaly's dividend goes down, and when the federal funds rate goes down, Annaly's dividend goes up.

Since the federal funds rate is essentially as low as it'll ever go, when it finally increases in 2014/2015, Annaly's dividend will likely decline.

Regarded Solutions: Procter & Gamble has a consistent yield and nothing is ever a guarantee. We can almost count on the 2.5% all the time from PG more than the 13% on NLY. However, with the right allocation of available funds in a stock like NLY, we have been able to count on roughly a 8-13% yield, with the drama of course, since Annaly went public in 1997. So, yep, you're right as usual, but I am just more right.

Argument 4: Interest Rate Environment

As far as the spread environment, we cannot ask for a more stable interest rate environment for this sector to play in, thanks to the Fed's ZIRP (zero interest rate policy) keeping the short term rates at virtually zero, as well as the Operation Twist programs, which have kept the longer term rates rather stable. Seems to me that some of the uncertainty in interest rates have been mitigated, at least for a few more years.

But the bears argue this is bad for Annaly investors for two reasons. First, that nice dividend check disappears. Second, as an mREIT, Annaly's worth is tied to its dividend, so investors are looking at capital losses as well

Regarded Solutions: I agree with this assessment. If the interest rates invert, then the profits of Annaly will be negatively impacted, however, their use of less leverage (staying shorter rather than reaching for higher yields going longer) gives them the ability and flexibility to move quickly through the cycle. One should take a look at 2006/2007 when the 2 and 10 year Treasury yields were almost the same at around 5.5%. Annaly still made money and still was able to pay a dividend (a small one, but just for 3-4 quarters), so they do have the experience of trading around a tight spread, and have made money. By contrast, their competitors have not faced those issues yet, and take on more leverage than NLY does now, to temporarily pay more in dividends. I would not want to try squeezing through THAT exit when the owners of brand X shares start stampeding

Argument 5: Trends Aren't Forever

Skyler: Annaly's website sports a very impressive chart showing that since inception, Annaly has trounced equity REITs and the market alike.

This trend, however, may not last forever. As I examined in my article Why Dividend Growth Is More Important Than Yield, mREITs have actually significantly underperformed during previous historical periods. According to a very thorough 2003 paper by several economics professors titled "Interest Rate Sensitivities of REIT Returns," mREITs had a bad time of it in the '70s, '80s, and '90s.

Click to enlarge

Regarded Solutions: I really love this chart from Skyler, and he is correct that trends are not forever, but can't we say that about every stock on the planet? The trend is your friend until it isn't right? For right now, and for maybe more than 2 years, income seeking investors will hunt for yield. When they bump into these stocks (especially a more conservative "risk" one) that can give income seekers great dividends, I do not believe the bottom will fall out of the share price that quickly.

As far as the 70's, 80's and 90's, well those are decades in the rear view mirror and as investors we need to be laser focused on the now, and try to be forward looking. Isn't that all we have? The past is gone, the present is now, and we can only forecast for the future. With the Fed giving us an open playbook virtually, we even have some really good clues for this lovely sector!

Let me put up another chart I love:

Click to enlarge

My Opinion

Frankly, we both make compelling arguments, however I believe that as long as an investor is aware of the inherent risks of the mREIT sector, then we can monitor the arena for any significant change in the basic fundamentals.

Annaly has been a public company since 1997 and has stood the test of time as well as just about every interest rate environment, including a completely flat yield curve spread.

Will it be different this time? My money is on NLY stock for as long as this horse can run!

Disclosure: I am long NLY, AGNC.