For Q2 2012, Annaly Capital Management Inc. (NLY) reported a Total Interest Income of $866.3M (Q1 $854.8M), which represents a $70.8M decline from same-period income (Q2 2011 $957.1M). Even though the company's average interest-earning assets increased on a period-over-period basis (Q2/12 $116.5B vs. Q2/11 $94.7B) by $21.8B, the yield on these assets declined, on a comparative basis (Q2/12 3.04% vs. Q2/11 4.04%) by around 1%.
Analyzing NLY's Q2/12 results on an YTD basis, Total Interest Income (06/12 $1.7B vs. 06/11 $1.8B) declined by $0.2B over the first six months of the current fiscal year. Interestingly though, while the company posted an increase in its average interest-earning assets by $19.2B on a 6-month comparative-basis (06/12 $111.1B vs. 06/11 $91.9B), these increased assets yielded approximately 0.79% lower returns (06/12 3.13% Vs. 06/11 3.92%).
NLY posted a Q2/12 net loss of $91.2M (Q2/11 net income $120.8M), which equates to approximately $0.10 basic loss (Q2/11 basic income $0.14) per average common share. The company ascribes this decline in Net Income as being primarily attributable to prior period unrealized losses on interest rate swaps (Q2/12 $637.3M vs. Q2/11 $466.7M). On a dollar basis, Net Income declined by $212.0M (Q2/12 -$91.15M vs. Q1/12 +$120.81M) since the last quarter.
On 22 October 2012, key valuation metrics from Morningstar indicate that the company trades at a considerable premium (50.0) on a ttm P/E basis when compared to the industry average (31.4). With such high multiples, at initial glance, it would indicate the stock is significantly overvalued at current levels. However, the company is also trading at a Forward P/E of 9.4, with a healthy PEG Ratio of 28.6, indicating that, when taking a forward-looking perspective, investors definitely see NLY as a value and growth story.
NLY's earnings yield (2.0) does not stack too well when compared with the yield of the S&P500 (6.6), nor the yields of a 30-year T-bond (2.9). However, it boasts of a significantly better dividend yield (13.6) compared to the average index (6.6). Historically rising dividend yields (07/5.72%, 08/13.11%, 09/14.64%, 10/14.79% and 11/15.29%) are an affirmation of investor confidence that the company will do well moving forward.
What Does the Future Hold?
As one of the largest players in the Mortgage REIT (mREIT) sector, NLY has to content with a number of headwinds looking forward. Its operations could be impacted by several factors over which the company does not have direct control over, the most significant of which is interest rate risks. The company's major source of revenue is the spreads between interest earned on interest-bearing assets, and the interest paid on those assets. As interest rates can be impacted by any number of variables - tax policies, government monetary decisions, other national and international political and economic considerations - future revenue growth will primarily be determined by such events.
The future of the financial stability of Europe will also bear heavily on how NLY performs. The company has sizable exposure to Europe, in terms of financing provided to it by European institutions under repurchase agreements, or interest rate swap arrangements. Should any of those institutions face financial collapse, and not be rescued through sovereign bailouts, then NLY could be exposed to considerable counterparty risks.
Company management is aware of these risks, and has put in appropriate interest-rate hedging and reverse counterparty margin call strategies in place to mitigate some of those risks. Still, just as a rising tide raises all ships, an ebbing European tide could have ripple effects on future growth and earnings for NLY and the mREIT sector as a whole.
The speed of mortgage principal prepayments could also impact the company significantly. On a year-over-year basis, prepayments for Q2/12 were 19%, compared to 11% during the same quarter last year. On a more positive front, the company's decision to repurchase $1.5B worth of outstanding common shares over the next twelve months should bode well for improving shareholder value in the short to mid-term. Additionally, the possibility of another Fed-backed stimulus package (QE3) could further help to buoy book value of mREITs, including NLY in the intermediate to long-term.
Make or Break For Investors
Of the three Wall Street analysts following NLY, one favors the stock with a "Buy" rating, while two others are proposing a "Hold". This situation creates a bit of uncertainty for the average retail investor - should they jump in with both feet (Buy), or should they remain on the sidelines (Hold) for the time being, until additional guidance is received.
A discounted earnings plus equity model, developed by Efsinvestment and applied to NLY, allow suggesting that these days the company is trading at a fair price.
My "Hold" investment position for NLY is based on the premise that, in the current financial environment, I believe that investors are hungry for dividends. With a double-digit yield, it is easy to see how NLY offers a great opportunity for yield-hungry investors, especially when other forms of "safer" investment options (Term Deposits, T-Bills) don't offer any compelling case for investors to flock to them. The chart below allows suggesting that NLY is a solid and regular dividend payer.
(click to enlarge)
Given the various overhangs on the company's future, that we discussed earlier, it might be prudent however to hold off taking any large position in NLY for now. Over the next several weeks, the results of the U.S Presidential election, the U.S Fiscal Cliff situation, and monetary and fiscal policy decisions by the Europeans should give investors more clarity on mREITs.
As indicated in the chart above, the company offers an extremely attractive total-return value proposition, when contrasted with leading financial indices. The next several weeks should provide us with additional guidance on whether this trend is likely to continue.
Bottom Line
According to given the above facts, I would classify Annaly Capital Management as a Hold for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
