The third round of quantitative easing will have multiple effects on the mortgage REITs sector. Where it will increase the book values, it will also have the impact of decreasing the interest income and accelerating prepayments, which are already at their peak since 2005. Annaly Capital Management (NLY) can expect both of these risks to be realized in the coming quarters. However, we believe the risk will not lead to another dividend cut. The stock offers an unmatched sustainable dividend yield of 12.4% with an added advantage of an extensive stock repurchase program. Therefore, we recommend our income-oriented investors to go long the stock to benefit from the elevated shareholder distributions. However, further acceleration in bond buying by the Fed will have a significant negative effect on the stock.
Stock Repurchase Program
Contrary to most of the mortgage REITs, Annaly Capital Management announced the launch of a massive stock repurchase program, where the company aims to purchase $1.5 billion worth of its own stock. The move will result in stock price appreciation for the company, at least for the short term, due to the obvious increase in demand for the stock. The move comes after the announcement of change of management at the top level to support the chairman and CEO of the company in his ongoing treatment for cancer.
While most mortgage REITs have been busy offering shares in the market to expand their operations, Annaly's move signals the management's intention of implementing no expansion programs in the near future. The stock is currently trading in line with its book value. Therefore, another possible reason for such an elaborate stock buyback program is that the management thinks that the market is not evaluating the company's asset portfolio appropriately.
The stock currently offers a dividend yield of 12.4%, which is well backed by a 24% operating cash flow yield. The company generated $2.4 billion from cash flow from operating activities, while it paid $2.04 billion in annual dividends during the year 2011. This makes the cash dividend coverage ratio of 1.17 times. This reflects the fact that the company could sustain some decrease in its net interest income if the interest rate spread declined. Under pressure from QE3, the company has already announced a 9% decline in its quarterly dividends. The new quarterly per share dividend comes out to be $0.5.
Assuming the same number of shares outstanding as at the end of the second quarter of the current year, the company will have to make a payment of $490 million in quarterly dividends. The company has composed its portfolio in such a way that if a onetime instantaneous 25 basis point decline in the interest rates occurs, it will bring a 1.12% increase in the projected net interest income of the company. Therefore, at the current level of interest income the future dividend distribution does not seem threatened.
In an earlier report, using the interest rate sensitive gap between the rate sensitive assets and liabilities, we already analyzed the bear case for Annaly Capital Management. The company provides in its SEC filings a positive rate sensitivity gap of $16.7 billion, meaning it has more rate sensitive assets than rate sensitive liabilities. Therefore, we analyzed in a bear case scenario the company's interest income would decline by $127 million. In such case, we believe, income oriented investors can expect a cut in dividends.
The impact of QE3 has been mixed on mortgage REITs. Where it would result in a decline in interest rates and a resultant increase in the book values, it would also contract the interest rate spreads that Annaly Capital earns and accelerates the prepayments. Prepayments during the month of August have already reached their highest level since 2005. The Conditional Prepayment Rate (CPR) of 19% for Annaly Capital Management remained flat during the second quarter of the current year, as compared to the linked quarter. The current CPR is considered significant when compared to American Capital Agency's (AGNC) CPR of 10%.
The stock is currently trading at a 2% moderate discount to its book value, while analysts have bull and bear price targets of $20 and $13, respectively, for a share that is currently trading at $15.9 per share.