Annaly Capital Management (NLY) reported earnings for the third quarter of the current year that missed consensus mean estimates by 4%. The company reported earnings per share of $0.45 vs. $0.47 per share expected by 21 analysts covering the stock. Earnings were hit by a decline in the net interest margin, which decreased to half of what the company earned a year ago. QE3 is said to be the reason behind such a significant decline.
The following table offers a snapshot of the company's performance during the past quarter.
Click to enlarge image.
During the third quarter, the company generated interest income of $761 million, vs. $886 million generated in the second quarter of the current year. The 14% quarter-over-quarter decline in interest income was a clear impact of the flattening of the yield curve as a result of the implementation of QE3, partially offset by a 9.4% sequential increase in interest yielding assets. The launch of QE3 was announced by the Fed on Sept. 13, 2012. The central bank intended to buy fixed-rate agency mortgage-backed securities (MBS). Annaly Capital invests 93% of its entire assets in such securities. Prices surged for the securities that Annaly holds, decreasing their yields. This can be seen in the 50-basis-point sequential decline in the average asset yield that the company earned during the past quarter. Asset yield plunged to 2.54% at the end of the most recent quarter, from 3.04% at the end of the second quarter.
The company clearly benefited from the prolonged ultra-low interest rate environment, as demonstrated by an 11-basis-point year-over-year decline in the cost of funds. On a sequential basis, the cost of funds for the third quarter remained flat. Despite the year-over-year decline in the cost of funds, the interest expense of $182 million was up vs. the interest expense of the prior quarter.
The decline in interest income and a surge in interest expense resulted in a 20% quarter-over-quarter decline in net interest income. The company earned $579 million at the end of the third quarter, vs. $720 million at the end of the second quarter. Net interest margin declined 52 basis points sequentially to 1.02%, while it declined 106 basis points compared to a year ago.
Other losses declined 62% from a quarter ago to $278 million on higher net gain on disposal of investments, partially offset by net loss on extinguishment of convertible senior notes. Net gain on disposal of investments was $142 million at the end of the most recent quarter, vs. $94 million at the end of the previous quarter.
Operating expense of $63 million during the quarter remained largely flat when compared to the expense of the previous quarter. The company posted a bottom line of $225 million at the end of the third quarter, vs. a loss of $91 million at the end of the previous quarter. However, the bottom line was still more than 75% below what the company earned a year ago. The net interest margin of 1.42% for American Capital Agency (AGNC) declined 23 basis points sequentially, while it plunged 72 basis points on a year-over-year basis. American Capital Agency, like Annaly, invests exclusively in fixed-rate securities that the Fed is buying under QE3. Therefore, both experienced a significant decline in their net interest margins during the past year.
At the end of the third quarter, the leverage ratio remained stable at six times, as compared to the prior quarter. However, it is still above the ratio of 5.5 times from a year ago. The conditional prepayment ratio of 20% increased from 19% at the end of the second quarter.
After a $0.05/share quarterly dividend cut, the company offers a dividend yield of 12.6%, which is well backed by an operating cash flow yield (TTM) of 24%. Operating cash flow generated by Annaly during the past year was $2.4 billion, while $2.04 billion was paid in annual dividends during the same year. This makes the cash dividend coverage ratio out to be 1.17 times. The company declared third-quarter dividends of $0.50 per share. Considering the company's outstanding shares, we believe Annaly will have to pay $487 million in dividends, which is 84% of the interest income that the company earned during the same third quarter. This leads us to believe that the company can only sustain some decline in net interest margins going forward, given the current low interest rate environment, before another dividend cut could be expected.
In conclusion, we believe that in the current scenario if the Fed decides to accelerate bond buying, companies like Annaly and American Agency would face significant pressure as far as their net interest margins are concerned. Therefore, we recommend investors go long mortgage REITs that invest largely in non-agency mortgage-backed securities.