Model For Assessing The Sustainability Of Annaly's Dividend - Q1 2014 Update

| About: Annaly Capital (NLY)


Unrealized gains and losses on the bulk of NLY’s assets do not appear on the income statement.

Net interest income does not include all the expenses of interest rate swaps.

Non-GAAP based model is required to assess dividend sustainability.

Net interest income and leverage declined in 1Q14 vs. the prior quarter.

Model indicates current dividend rate is not sustainable unless these changes are reversed.

This article applies a methodology described in my prior articles to assess whether the dividends paid by Annaly Capital Management, Inc. (NYSE:NLY) are sustainable in light of the latest available information (1Q14 data) on leverage and interest rate spreads.

The bulk of NLY's assets consist of mortgage-backed securities and debentures issued by Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) or the Federal Home Loan Banks (together, "Investment Securities"). These securities account for 94% of NLY's asset portfolio as of 3/31/14. NLY relies primarily on short-term borrowings to acquire Investment Securities with long-term maturities. The shape of yield curve, the spread between returns on assets owned and the interest paid on amounts borrowed to purchase these assets, and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of profitability.

NLY's Investment Securities are classified for accounting purposes as "available-for-sale." They appear on the balance sheet at fair value, but unrealized gains and losses on these securities do not appear on the income statement. Instead, such gains and losses and are reported on the balance sheet as a separate component of stockholders' equity. In addition, net interest income as measured by GAAP does not include all the expenses of interest rate swaps. The portion classified as "Realized gains (losses) on interest rate swaps" appears below the net income line, buried in the statement of comprehensive income.

Management therefore uses a non-GAAP definition of net interest income. This is referred to as "economic net interest income" and is derived by deducting economic interest expense from interest income. Economic net interest income for recent quarters and the trailing twelve months ("TTM") ended 3/31/14 and 3/31/13 is presented in Table 1 below:

Table 1: Figures in $ Millions, except percentages; yields annualized. Source: company 10-K, 10-Q and 8-K filings and author estimates

The next step in the analysis of NLY's dividend sustainability is presented in Table 2 below:

Table 2: Dividend sustainability model. Source: company 10-K, 10-Q and 8-K filings and author estimates

Table 2 provides a simple model describing NLY's bread and butter business of using short-term borrowings to acquire Investment Securities. The model highlights the improved performance in terms of net interest rate spreads for 3 consecutive quarters through 4Q13 (line 4). That, coupled with dividend reductions (line 13), produced positive coverage (i.e., above the 1.0 threshold in 4Q13) after 8 consecutive quarters of below 1x coverage. However, net interest income declined in 1Q14. This was accompanied by lower leverage and returned NLY to negative (i.e., below 1x) coverage (line 14). The current dividend again does not seem to be aligned with what NLY's basic business model can produce under 1Q14 conditions. A combination of an increase in leverage and/or interest rate spreads is required for the current dividend yield to be sustainable by NLY's bread and butter business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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